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Still Learning from LaserBond (ASX:LBL)

26/08/2019

Trav Mays
Follow @MaysTrav 

Laserbond (ASX:LBL) has just released their latest results and what a cracker, exceeding their earlier guidance, the market has rewarded them with a 17.7% jump in the share price.

I recently wrote a post about LaserBond, within which I highlighted some of the great work they have been doing over the past couple of years, so I won't go over that detail here. Feel free to check that one out first if you aren't familiar with them. I will instead go over their latest result to explore, in a little bit of depth, where I went wrong in my original thesis. I will also update it accordingly and attempt to calculate if LaserBond is under, over or priced about right at the moment.

Company

LBL has more than doubled their earnings per share this year, generating just shy of $0.03 per share, up from $0.13 in FY2018.  

The bulk of this increase came from the products sector; PBT increased by 233%, whilst Services increased by a smaller, but still very impressive 20%. The technology division didn't record any revenue in 2018, its growth rate is therefore undefined. Trust me on this one, please don't check it.

Math Joke :)

These results are amazing, but the real standout in the report, in my opinion, is the level of LBL's operating leverage. Operating leverage, for those who may not know, is a companies ability to disproportionately increase operating income with an increase in revenue. When we look at each segment's pcp growth rate, products looks to be the segment with the largest operating leverage, a 62.8% increase in revenue resulted in a 232.8% increase in profit before tax.

To calculate the degree of operating leverage, we simply divide the growth rate of EBIT by the Growth rate of revenue. As you can see, Products has a higher Operating Leverage than Services, with every 1% growth in revenue adding 6.36% growth to EBIT. Services is whilst lower, is adds an impressive 3.1% to EBIT for every additional 1% on the revenue line.

This high level of operating leverage seeps down into the margins, helping to lift them all and take the overall EBITDA margin to an all time high of 21.6%.

A high degree of operating leverage is the result of relatively low variable costs and relatively high fixed costs. As fixed costs, as their name would suggest, are fixed irrespective of the number of units produced, an increase in the production rate will spread the fixed cost out more thinly, thereby reducing fixed costs per unit and subsequently total costs per unit. The cost per unit equation is therefore

Total cost per unit = (Fixed Cost/no. of units) + Variable costs

Operating leverage is however a double edged sword, helping to boost profits when revenue increases, but if sales are not high enough to pass the break even point, they can have  a large impact on profits. A simple way to think about the power of operating leverage is by imagining an underutilised factory. If we have 4 machines and 2 workers, employing 2 additional workers to operate the 2 unused machines wont increase expenses very much, management, front of house, building expenses etc are already being covered, but the additional workers, after some training, will double output, thereby halving the fixed cost per unit. The obvious conclusion from this simple example is how does a company make their factory or workplace more efficient? The crux of the problem is the elimination of pain points or wasted movements, things that are currently being done but could be eliminated. From a top level viewpoint, things such as complicated software or the company layout to things at the individual employee level, desk layout or time management. This is one area that LBL has excelled in. They implemented Lean manufacturing back in 2014, purchased new equipment and have put on an arvo shift for both facilities, the results of which has increased margins across the business.  

The tricky part is that we are not privy to a companies constantly changing fixed to variable cost relationship or a breakdown of the number of units sold. We are however given information such as when companies purchase new equipment or implement Lean manufacturing, but the impact is rarely passed onto owners. We must therefore make several assumptions about the operating leverage when forecasting and we all know what assumptions make out of you and me. 

One other thing that was excellent to see is their continued focus on R&D. They actually increased their R&D spend in FY19, which will no doubt lead to new products, helping to further push future profits higher. (Mining expenditure for 2019 hasn't been released yet).

Evaluation

In my previous post I used a simple method to try and calculate a possible share price if/when LBL reaches their $40m revenue milestone. Within which I used a conservative EBITDA multiple of 16%, which was in the middle of the HY19 and FY18 EBITDA multiples. I failed to take into account LaserBond's operating leverage, if I had, I would have used a higher multiple, probably around the 17.9% earned in HY19, but still no where near FY19's 21.6%.

I have reused that same analysis here, but have updated it to a higher EBITDA multiple of 21%. I have again used their $40m milestone (predicted to be achieved in 2022), the 5 year trailing EV/EBITDA multiple of 8.7 and a multiple of 10. If they are able to generate $40m and maintain these multiples, we are looking at gains from 28% to as high as 55%.

These are some very encouraging potential gains, which leads us to our next question. How likely is it that LBL will be able to generate $40m in the next 3 years? That is after all what this thesis has been built on, without which, it holds up about as well as a wet tissue.

LBL has been very forthcoming with their projected sales growth in all three segments, but more specifically within the services and technology segments. We can therefore use these and their $40m in revenue milestone to calculate the rate of growth required in the products segment and conclude from this, if , in my opinion, it is  feasible. In their FY19 annual report, LBL stated that "it is expected the Services Division will continue to deliver growth in revenue at similar rates", having grown at 11.3% this year, we will therefore use a compound annual growth rate (CAGR) of  11% over the next two years. Within the technology division, their "target is to provide one additional equipment sale during FY20 and two each year from FY21" which "provide revenue of approximately $1.2-$1.7 million". Along with the initial sale revenue, each piece of equipment comes with "ongoing consumables supply for the term of each agreement with each piece of equipment supplied capable of using up to $1 million per annum in consumables". We will therefore assume each unit sells for $1.5m and generates in consumables, $1m for a full year and $0.5m in the year it is purchased. With their sale of a unit in FY19, they currently have 2 units in operation. The unit's will also be generating a licensing fee which I haven't included (LBL states this will be worth hundreds of thousands per year per contract, but didn't give any figures), but I believe by using the top end of possible consumable revenue we should be OK. I think we may still be somewhat optimistic in the consumables part of the analysis, they already have one unit in operation, but all of the technology division's FY19 revenue is made up of $1.95m from the sale of the unit and $0.415m in consumables for that unit, no consumables on the original unit. But as you can see they sold the unit for $1.95m this year, $0.45m more than what we will be assuming, I therefore believe that it will iron itself out.

When we put all of this together, we can see that the Products Division is going to need to grow by $7.6m between now and 2022, which will require a CAGR of 22% per year, which seems fairly resonable. They grew by over 60% this year, so 22% shouldn't be too much trouble.

However, the larger a company gets, the harder it is for them to grow, so where will this growth come from? Their newest product, which appears to be their main focus for the growth, is their carbide steel mill rolls. They successfully broke into the North American market this year, which according to LBL is over 15 times larger than the Australian market. In FY19, LBL sold $0.285m worth of steel mill rolls in Australia, assuming that they are able to get the same level of market share in North America by 2022, this will contribute $4.27m towards the targeted $7.6m. I'm not suggesting that they will necessarily penetrate the American market to the same level as Australia by 2022, but when we play around with a sum of the parts analysis using (in my opinion) reasonable assumptions, we can get to $40m pretty quickly. That being said, I'm reminded of the Mr. Ronald H. Coase's quote, "If you torture the data long enough, it will confess.”

To try and determine if LBL is currently over, under or priced right, I have reused the revenue analysis above and expanded it to try and calculate future EPS values, assuming the NPAT margin stays flat at 12.1%. As you can see, if we attach a P/E of 20 (which I think seems pretty reasonable given the growth of LBL) we have a PEG of 96.2. As I'm sure you all know, Peter Lynch said a PEG of 100 represents a company that is perfectly priced, it appears that the market is assuming margins will stay pretty steady in FY20.

But is steady margins a reasonable assumption? LBL has made a number of changes in 2019, most of which effects wouldn't be seen in FY19's report, they include

1. Increased the SA shop floor staff by 33%, 
2. Put on an arvo shift at both sites, which is still expanding and 
3. Increased P&E by $2.41m in the second half. This included an automated dual station high power LaserBond cladding system and a CNC horizontal borer, which doubled the horizontal boring capacity.  

We can therefore, using FY20's revenue estimated above, a P/E of 20 and a range of potential FY20 NPAT margins, estimate a range EPS growth rates and from this PEG values. If we assume a NPAT margin will increase to 13%, EPS would have grown by 29%, which results in a PEG of 66.9, indicating that LBL is currently undervalued.

Conclusion  

In my original post, I concluded that LBL is an amazing company that has achieved remarkable results, the poster child of a turnaround. But I believed that the market had priced LBL pretty well, hedging this statement by referencing Mr. Matt Joass' article on inflection points and our inability to extrapolate anything in any way other than linearly. I stated "I am wondering if I am falling into this trap now, maybe I am working off estimate 2 or 3, when I should be working off estimate 4". I did work off estimate 2 or 3 because I missed LBL's operating leverage, I didn't realise just how long their lever is and therefore missed out on the roughly 40% gain since I wrote that, just under 2 months ago.

Am I succumbing to the same issue again? I don't think so, but I could be succumbing to a different issue. We all know Mr. Buffet's quote "What the wise do in the beginning, fools do in the end", maybe this is the end and I'm just a fool chasing a return I missed from earlier in the year. Did I unintentionally use too high a NPAT margin to justify my answer? Maybe, that would fit in nicely with me being a fool, especially when we consider that there is a limit that can be levered out of operations. If we continue the above example, once the 2 additional employees have been hired, the company will need to purchase new equipment and/or start to do a lot of overtime, both bringing down the Op Lev value. Employing techniques such as Lean Manufacturing helps, but with each new improvement, they bring with them a diminishing level of return. Having said that, the large CAPEX purchases happened in the second half of FY19 and there is still room to expand the arvo shift and therefore "fill up a few more machines", further reducing the fixed costs per unit. I therefore think that there is still value at these prices, assuming that LBL can hit their revenue growth rates and continue to expand the margins. 

So what did I learn? I learnt that whilst I failed to think about LBL's operating leverage, the root failure was not thinking like a business owner. If I had, operating leverage would have been something I definitely would have thought about, especially with all the improvements they have been making. Which would have influenced my evaluation, but would it have been enough to over come my anchoring on the prices from less than a year ago? I hope so, but that's an impossible question to answer. It's easy to forget that we are business owners, especially when you aren't privy to all the info and aren't on site, but it is definitely something I need to pay more attention to.

As always, thanks a lot for reading. I am on Twitter Follow @MaysTrav and Linkedin  if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point and don't forget to subscribe to ensure you don't miss out on my new posts. 

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

Sources:

1. https://mattjoass.com/2018/11/10/inflection-point-investing/

The author is a current owner of LaserBond, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action. Please refer to Disclaimer page for a full list of disclaimers.  

FY19 Portfolio update ASX:LBL, SOP, DEM, 2BE, XRF, BSL, SSG

04/09/2019

Trav Mays
Follow @MaysTrav 

Today I would like to give an update on all the stocks within my portfolio and see how my original thesis has/is playing out. I plan to write another post about other companies that aren’t in my portfolio but I have written about in the past to test my thesis and hopefully learn a bit more. 

I run a very concentrated portfolio because the benefits really resonate with me. I completely understand diversification and its merits, but I struggle to keep up with this many stocks, so adding another 13 or so to get diversified sounds like a nightmare, but each to their own. The figures in the table below are just a snap shot as of end of business day today (04/09/19) and should not be looked at as an indication of performance.

*Weighted average price

LaserBond (ASX:LBL)

I originally made a mistake with LaserBond, to ensure that I learn from it, I have given it its own post, so I won't rewrite that here. You can read all about my mistake here and the original here.

BlueScope Steel (ASX:BSL)

Original thesis can be read here

After going through my analysis I decided to sell BSL today (04/09/19) for $12.33, netting me a return of 11.6% + dividends - brokerage and tax in 9 months, pretty happy with that. The reason I decided to sell is due to increased uncertainty. The trade war continues to drag on, with steel being a key lever both sides are using to hurt the other. BSL has also been spending a lot of money on buybacks, helping to keep the stock price somewhat elevated despite the decrease in profit and predicted large decrease in FY20. If the buyback where to stop before the trade war ends, I would imagine it would hurt the share price in the short term. They have also just started proceedings with the ACCC over alleged steel price fixing. It doesn't sound like they have a very solid case, the ACCC's Chair Mr. Rod Sims stated that due to them only having 6 years to begin civil proceedings and that time is almost up, the "ACCC has determine it is appropriate to commence such proceedings against BlueScope and Mr. Ellis", not the most confident sounding reasoning, but adds to the uncertainty around BlueScope. Whilst I think it is still undervalued, I would rather wait and watch on the sidelines than continue to own a stock whose profits are so heavily tied to the a ongoing disagreement between two of the most powerful people on the planet and get back in if it does happen to go down. 

Synertec (ASX:SOP)

Original thesis can be read here

Synertec looks to be playing out as expected, albeit, slightly postponed, except for their revenue, I didn’t predict anywhere near that big a jump (111.2%). They also recorded decent increases further down the income statement, with EBITDA returning to positive figures that being said, they did produce a loss in FY19 of $85k.

The original thesis revolved around a new accounting standard (IFRS 15, introduced on the 1st January 2018) temporarily disguising earnings, which continues to be the case. We can see this by looking at the disconnect between operating cash and EBIT, EBIT for FY19 was a loss of $40k whilst Operating cash was a positive $0.83m. We can also see that despite SOP recording an EBIT loss in FY18 and FY19, cash and cash equivalents has continued to increase. If you have read my initial post, you would have seen the simple calculation process that reveals SOP's true earnings, which accounts for all but 50k of the 2.4m increase in the cash balance, as calculated at HY19. This hidden profit, I believed, would eventually be put through the income statement, boosting profit and would be the catalyst for a ~40% stock price gain. But despite the deferred income decreasing by $2.4m in FY19, SOP produced a loss, so what is going on? 

I believe the missing profit has been postponed due to some untimely project completion dates; $8.46m worth of projects plus a custody transfer skid were delivered within the first 2 months of FY20. Under IFRS 15, contracts with multiple performance obligations record revenue as each performance obligation is meet, contracts with payments upon completion are recorded "when control of the goods transfer to the customer". Whereas "operating expenses are recognised in profit or loss upon utilisation of the service or at the date of their origin". This means that whilst expenses are recorded as they occur, revenue is recorded only after a milestone is achieved, any cash received before the milestone is recorded as Deferred Income on the balance sheet under Liabilities. As the projects pass their milestones, the deferred income reduces as it is recognised as revenue. The final portion of the revenue both received as cash and recognised on the P&L for the projects finished early FY20, I believe, would have occurred on delivery in FY20, hence the lower deferred income and loss for FY19. While we are not given figures for the custody transfer skid or contract specifics, it's a good bet that they would be settled as cash on delivery, revenue would therefore be recorded in FY20, its costs however, would have all been recorded as they were incurred, the majority of which was in FY19. The same can be said for the performance obligation contracts, the final portion of the payment will be received in FY20, but a large portion of costs would have been expensed in FY19. The 238% increase in the materials and services expense and the 2H19 operating cash loss of $0.42m, I believe, help to validate this point.

Whilst a good portion of the revenue and profit disconnect can be attributed to the accounting standards and untimely completion dates, part is due to the revenue increase coming from the lower margined fixed priced project segments. This segment's revenue increased by 166%, making up 87.3% of total revenue, whilst their other division, rendering of services, decreased by 13%. It would appear that SOP is pricing their projects with a low margin to help win market share, allowing them to show off their skills and talent and to win customers over. Clearly there is a short window in which a strategy like this can be used, but if used correctly, can really help to boost long term shareholder value. 

SOP continued to invest in themselves during FY19, they in actual fact accelerated their spend, with business development more than doubling and Employee and Super costs increasing by $1.33m or 21%.

I believe SOP is still good value at current prices, they have no debt, are op cash positive and according to their investor presentation have a medium term target of $40m revenue, with above industry average margins. They seem to be focusing on their custody transfer skids as a large driver of growth, a little more sales info about these units, projected sales volume, a ball park sale price and margin would be appreciated. But nothing stood out as a worry for me, so I'm going to continue to hold. The 1H20 report is the one I am really interested in, within it will hopefully be a return to healthy margins and proof of my thesis playing out, bring with it the ~40% gain I'm predicting. Fingers crossed on this one, I do however believe the risk reward ratio is positively skewed in my favor. 

Shaver Shop (ASX:SSG)

Original thesis can be read here and the half year result here

Shaver Shop along with a number of other large retailers had a pretty good year. Despite the constant retail apocalypse discussions, SSG grew NPAT by 6%, they hit the lower end of their EBITDA guidance, 12.5m and increased their online sales by 30%, which contributed 12.6% to total sales. But more importantly, they grew LFL sales, 1.1% overall and 4.8% when you exclude Daigou sales.

Over the year they have made a number of improvements, they opened 6 new stores and bought back one franchise. They also improved their website, initiated a number of online incentives and completed 8 full store refits. 

Using the PEG ratio, SSG looks priced a little bit higher than it should be, currently sitting on a PEG of 1.5, when using FY19's earnings growth rate of 6% (P/E = 9.14), but is this level of growth justified? So far in FY20, they have increased LFL sales by 9.5% and bought back 2 franchises. Within FY20 they are planning on increasing their marketing spend back up to FY18 levels and refitting 5 - 10 stores with the new design. The franchise buy backs are especially important as they are typically in locations that generate higher sales per store. So they are definitely off to a good start to the year. So it does seem like 6% is a bit low, but it is far too early to tell, as with most retailers, so much of their revenue comes from the holiday season, that any prediction without a little bit of holiday data is pretty much pointless.

During the conference call, Mr. Cameron Fox, current CEO, made an interesting comment. He stated that SSG are using each store as a type of warehouse, whereby as an item is purchased online, the sale order is sent to the store nearest to the customers location, who then, during down periods, package and post the online sales. Clearly this is an excellent idea to try and reduce postage times and costs, keep employees busy during down times and to combat Amazon's 2 day delivery, but one that would need to be managed really well. 

Given all this, I am going to continue to hold and watch, they are paying out a pretty healthy dividend, so assuming everything stays the same or doesn't deteriorate too much and I don't have any other company I want to buy, I'm happy to hold.

De.mem (ASX:DEM)

Original thesis can be read here

DEM on the surface didn't have a very good half, revenue decreased by 37% (HY19 $3.7m) whilst their NPAT loss more than doubled (HY19 -$1.8m). But when we have a look a little further down in the report, at the cash flow statement, a different story emerges. DEM increased their receipts from customers by 9.3% (HY19 $5.08m) and whilst they produced a operating loss of $0.8m the vast majority of it, ~74%, was from the first quarter, showing that they are making progress towards becoming operating cash flow positive. Not only that, but DEM is predicting to surpass CY18's revenue of $10.5m, with $9.5m worth of revenue having already been secured.

Whilst all of this is great, my key take away from the report is that DEM has begun to untether themselves from the mining and infrastructure industries whilst expanding their geographical footprint. DEM states that "while the vast majority of CY 2018 revenues were generated from the mining/resources and infrastructure segments, the revenue mix for CY 2019 includes some contributions from projects in the food & beverage sector". They went on to state that "a key pillar of the expansion strategy for 2019 is to aggressively target the high growth food & beverage and agricultural sectors across Australia". DEM is also expanding their geographical footprint, having set up two new offices in Adelaide and Melbourne, they also acquired PumpTech (07/08/19), Tasmania's equivalent of Akwa-Worx. A recent announcement  really highlights these two points. DEM reported on the 28/08 that they had received two purchase orders for a total of $0.35m, the first order was for a water treatment system in WA, ordered by a WA government organisation, whereas the second order was for a waste water treatment system for a company working in the Food & Beverage industry based in the Pacific Islands region. Whilst the value is not very high, it shows that they are making further progress towards these two goals.

Nothing in the report stood out to me as a worrying sign. I believe DEM is still great value at today's prices and will be able to generate a shareholder return around the 30 - 40% mark in the not to distant future, with the potential for a lot more over the coming years if management performs well and they get a bit of luck on their side. To achieve this, I believe DEM will need to continue to ride the increasing infrastructure spend all the while investing the proceeds back into the business, helping to further expand their customer base industrially and geographically. Signs of DEM departing from this plan is what I will be looking for in the future, but as they currently stand, I am going to happily continue to hold.

TUBI (ASX:2BE)

Original thesis can be read here

Tubi performed really well over the year, they exceeded my revenue prediction by $4.5m, increasing year over year by 82%. They did however fall slightly short on my NPAT prediction, missing it by $0.17m. Their NPAT figure however includes a $0.95m listing expenses, when we adjust for this, EBIT increases to $3m (9.74% margin) and after we remove $0.92m of tax (30% tax rate), NPAT increases to $2.15m (6.8% margin), ~$0.5m higher than I had predicted.

The reason my prediction missed the mark by so much, was due to 2BE generating revenue per month far higher than they have in the past. Over the last 6 months of FY19, Tubi had one plant producing in the Permian Basin which generated $14.4m, or $2.4m per month. My estimate had been the average between the revenue received over the year in NZ and the 2 months in the Permian Basin, $1.65m per month. At the time I was aware that the 2 months in the Permian Basin figure I had used was conservative and would increase as the team became accustom to the factory and site, but I didn't expect that they would be able to increase it by $0.75m.

Along with missing the mark on the rev/month, I was also quite a way off on the sale price of the Iplex unit. Due to me underestimating the amount of revenue per month the plants would generate, I overestimated the cost of the Iplex plant, its actual cost was AUS$9.28m, of which, 40% has already been received with the remaining 60% to be received when the plant is delivered in  FY20.

This report gave us some more valuable information about potential future revenue, so I believe an update of my old projection is warranted. To keep the projection conservative, I won't update the assumptions, despite the fact that the plants are currently ahead of schedule, I will just update the rev/month figure, the Iplex plant sale price and use FY19's adjusted figures. FY20's revenue therefore consists of 18 months (1.5 plants) of production at the new higher rate plus the remaining 60% of the Iplex plant. Whereas FY21's revenue is for 4 plants producing for 12 months, 2 at the new higher rate $2.4/month and 2 at the more conservative lower rate of $1.65m/month. 

The updated information paints 2BE in even better light than my original post. If we look one year out, we have a PEG of 60.7, whereas if we average the next 2 years growth, we have a current PEG of 24.5. Very encouraging figures, especially when we consider that I have not taken into account the Iplex service agreement, the fact that the plants are currently slightly ahead of schedule and my conservative assumptions. I did however make a large amount of assumptions, so this prediction should be looked at with skeptic eyes, you can see how wrong I was last time I tried to predict. Given all this, I believe that the risk reward ratio is currently in my favor and at current prices, continues to offer good value. If you'd like to read more about Tubi, I have referenced and linked Mr. Joshua Baker's report on both XRF and Tubi at the bottom of the XRF section, he goes into more detail about their progress and is an excellent read, highly recommend.

XRF Scientific (ASX:XRF)

Original thesis can be read here

XRF had a bumper of year, having gone through an inflection point, they increased revenue by 20%, NPAT by 109% and Op cash flow by 380%. They also moved closer to turning the German office profitable, recording 2 months in the 2H19 with positive profit.   

Along with this, PBT margins were increased across the board, with the standout being precious metals increasing to 7% and contributing 25% of the total PBT, up from 3% in FY18.

Ricky (twitter:@galumay) has put forth a number of valid arguments against XRF on twitter over the last couple of months. The two that I believe could pose a serious threat are, the fusion machine's ability to process large quantities and their long life span. As a mine site ramps up production, no additional fusion machines are needed to meet the  higher level of output and with the replacement life cycle being so long, without new mines opening up, the sales growth rate within this segment could slow down or reverse. If we look at XRF's geographical revenue breakdown we can see that within Australia there was a large increase in the Capital Equipment segment, but flat in Consumables. We can lightly infer from this (consumables can be purchased from competitors) that a good portion of these purchases are replacements, which is also confirmed by XRF within the report. Higher commodity prices are currently pushing mining profits up, with the ABC reporting a 12.5% increase over FY18, so assuming this continues we should hopefully see capital equipment profit levels hold steady or slightly increase over the next 2 - 3 years (This is really a guess). XRF have also stated that they are focusing on growing the services and parts divisions and are planning to launch new products in FY20, opening up new organic growth opportunities.

Excerpt from XRF Scientific FY19 annual report

The consumables division did well, the continued reduction in Lithium prices helped to push NPAT to record levels, increasing by 35.3%, despite revenue increasing by only 6.16%. Expanding XRF's consumables market share is another area of growth XRF has stated they are targeting. 

As I said earlier, precious metals is the real stand out here, this division appears to be on the cusp of an inflection point and in my opinion is where the future growth will stem from. The German division's progress to becoming profitable has allowed XRF to reduce their precious metal expansion costs by half ($0.3m FY19, $0.743 FY18) and to increase profits to $0.925m, up from $0.556m in FY18.

So what does this mean for XRF? I believe XRF is well positioned to continue to benefit from the pickup in the mining industry, giving them a couple of years of similar or higher capital equipment revenue, this along with their decrease in precious metals expansion costs, higher margins and organic growth opportunities will help to push earning higher into the future. Hopefully, they will pump a good portion of this back into the company helping to expand their product mix through either acquisitions or product development.  They have stated that they are looking to expand internationally and that they are pursuing M&A opportunities, so this is looking promising. The rest will probably be distributed to share holders, as Mr. Joshua Baker states in his recent article "Results Update: Platinum Gilded Numbers & Close to Light at the End of the Tube", "I believe the company would be able to make a material capital return to investors via a special dividend, which would also allow XRF to distribute the benefit from the $5.7m in franking credits accrued on the balance sheet".

Given all this, I am happy to hold, but I will be watching for any signs of Ricky's fears playing out. I am however going to push my estimate of the share price up to $0.3, with the possibility of more if management perform well and they continue to have luck on their side.

As always, thanks a lot for reading. I am on Twitter Follow @MaysTrav and Linkedin  if you’d like to connect or would like to chat, it’s always great to meet other ASX investors, especially those who have a different view point and don't forget to subscribe to ensure you don't miss out on my new posts. 

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

Sources:

1. https://www.livewiremarkets.com/wires/results-update-platinum-gilded-numbers-close-to-light-at-the-end-of-the-tube
2. https://www.abc.net.au/news/2019-09-02/gdp-economic-growth-slow-down-business-indicators-profit-mining/11471034

The author is a current owner of all shares outlined above, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action. Please refer to Disclaimer page for a full list of disclaimers.  

Synertec's Snapping Necks and Cashing Cheques (ASX:SOP)

14/08/2019

Trav Mays

Follow @MaysTrav 

Today we will be looking at Synertec Corporation Limited (ASX:SOP), Wini recently posted an evaluation on Strawman which kicked my FOMO into overdrive, so I had to take a deeper look . If you read my post on LaserBond, Wini will be familiar to you, for those who haven’t, he predicted the LaserBond rocket ship 3 days before it started its year long journey to a 244% gain. Obviously, there was a touch of luck in the timing, but that doesn’t take away from his correct selection of the company. Could that have just been a fluke? Possibly, we will still need to check his thesis, but he did also predict Advance NanoTek’s 1000% return (You read that correct, 1000%!) and I know he’s keen on XRF Scientific, so probably not J.

I’d also like to say that if you are not already on Strawman, you are really missing out, amazing place to not only get investment ideas, but to see how some of the great investors go about evaluating companies, such as Wini’s SOP thesis. I’d also like to say that I am in no way endorsed by Strawman, I do however reference them quite heavily in this post, so I thought I would advertise them to my 1500-2000 monthly viewers. I genuinely like their site and would like to see them succeed, probably for selfish reasons, where would I get all my investment ideas from if they shut down? J

Evaluation

Wini, within his evaluation, points out that due to a conservative revenue recognition policy, SOP has been understating the amount of cash they have been earning each year. The conservative policy Wini is referring to is IFRS 15, which pretty much states (I’m not an accountant so I have probably ballsed this up) that revenue is recorded at different time periods throughout the project to reflect the stage of completion of the project. More formally, “an entity recognises revenue to depict the transfer of promised goods or services to the customer in an amount that reflects the consideration to which the entity expect to be entitled in exchange for those goods or services”. For example, if you have a 2 year project with the customer agreeing to pay 60% before the work begins, 20% at a milestone in the first year and the last 20% at the end, SOP could choose to smooth the revenue out over the 2 years, instead of recording 80% in year 1 and 20% in year 2. The excess cash is then recorded on the balance sheet as a liability, under the term Deferred Revenue. This is a simplification, but I think it shows how the cash received and revenue can get out of whack, especially if you have a few contracts going at once.

As you can see below, IFRS 15, which was effective 1^st January 2018, has had a dramatic impact on the revenue to cash receipts relationship. Revenue having gone from roughly double cash in 2H17 was in 1H19 20% below cash receipts. 

Clearly the profitability of the company is being somewhat masked here. Wini recommends a simple calculation to uncover it. He states “as an example of what this conservative accounting means is 1H19 EBIT was $64k, while 1H19 operating cash was $1.25m. While the deferred revenue balance is not entirely profits, if you net off the work in progress asset balance (opposite of deferred revenue) and adjust for tax, you come very close to the $2.5m growth in the company's cash balance since FY17”. Makes sense, but let’s check his math.

As you probably guessed it, Wini was bang on the money, using his simple calculation process, we can account for all but $50,000 of the cash increase.

He then goes on to use an EV/Op Cash flow metric to estimate a potential valuation. He estimates that the Op cash for FY19 to be between $1-1.5m and recommends applying a 8 – 12x multiple, which gives us a share price of between 0.064- 0.11 and a return of between 44 – 144%, in other words, very healthy gains.

“But is it reasonable to apply 8 – 12x EV/Op Cash multiple to SOP?” That’s an excellent question. To find out, I have tabulated EV/Op Cash multiples for a number of engineering firms, obviously there is no like for like, but we can get companies in the same ballpark. To keep things simple and as relevant as possible, I have simply used the companies 1H19 Op Cash and figures from within the balance sheets, i.e. I didn’t go into each company’s notes; hence I have also included SOP without the term deposit. Encouragingly, SOP of the cash flow positive companies, has quite a substantially lower multiple than the rest, other than EVZ. If we include the term deposit, SOP is trading at less than a third of ZGL’s multiple, who is a leading specialist equipment manufacturer and niche engineering service provider.

EVZ’s low multiple got me curious, so naturally in the hope of finding another potentially undervalued company, I started to look in to them as well. EVZ, I haven’t had a proper dive, but it looks like despite their ability to generate a good flow of revenue, they have been unable to convert it into cash, which has forced them to raise capital. Over the past 3 years they have issued shares to raise $11.2m (69% of their current market cap), SOP on the other hand hasn’t needed to raise capital since re-listing. SOP even went so far as to issue out, to the legacy shareholders, the proceeds of the sale of legacy assets. 

The other thing we need to look at is Wini’s FY19 Op Cash assumption of $1-1.5m, which seems quite low given they earned $1.25m Op Cash in 1H19. But we need to remember that we are looking at cash not revenue, cash is quite lumpy, especially when it is dependent on milestones. Since relisting, SOP has spruiked 7 new or extended contracts, totalling $19.26m. Of these, none were completed in 2H19, they did however, complete 4 in July (These projects totalled $8.46m). The final cash portion of these contracts therefore will be received in 1H20, however, a large portion of the final push costs will be recorded in FY19, so I believe it is a good bet that cash in 2H19 will either be negative or quite small, therefore Wini’s $1 – 1.5m assumption sounds about right. Given all of this, what could be causing SOP to be trading at such a low multiple?

Company

SML Corp (SOP’s original name) was originally in the gold mining business, owning several plots in Victoria. They were however unsuccessful in this endeavour, and after several years of burning cash, SML stated on the 25^Th Feb 2016, that “with the company’s current cash burn rate, unless there is a substantial turnaround in the current conditions and investment sentiment for the mining sector and commodity prices, the outlook for the company in the short and medium term is not positive”. They therefore sort to change “the nature of its business and activities to property development, initially, in Asia where there are numerous opportunities for relativity high returns in the short term with relatively low capital costs”. This was planned to occur through the acquisition of a private Singaporean property development company called OSC Group, however this fell through in September, with the board stating that they “will continue to actively seek opportunities through, investments, mergers and acquisitions for the company to ensure its long term viability and prosperity”. 6 months later (10/03/17), SML stated that they would be purchasing Synertec, turning them into the speciality engineering firm we know today. The whole process was finalised, with SML taking on the name Synertec and being reinstated on the ASX at the start of August (09/08/2017).

SOP had pivoted away from being a holder of gold mining assets, to a speciality engineering firm, which if you are a fan of the podcast “Masters of Scale”, you’ll know that that is a massive red flag. Reid Hoffman (Co- founder of Linkedin and host of Masters of Scale) frequently points out that “The most successful pivots stay somewhat close to the company’s original mission”, clearly SOP did not. But SOP’s pivot wasn’t typical, they didn’t simply point the company in a new direction and start again, it was a reverse acquisition, they purchased Synertec, slashed and burned all the old parts and kept on some of Synertec’s management. These last two points are extremely important. Mr. Hoffman says “You can pivot from failure to success, but only if you slash and burn the rest of your business”. The slashing and burning gives the leadership team the ability to develop a new vision, focusing the workforce on a common goal, whilst simultaneously giving everyone a sense of purpose and a feeling of comradery. If you have ever worked for a great leader you will know what I am talking about, the human beings need for purpose is such an amazingly powerful force, especially when you couple this with our belief that we as individuals are all above average (To find out more click here or here). It results in high moral and high productivity, as Mr. Dan Cable and Mr. Freek Vermeulen point out in their Mckinsey article “Making Work Meaningful: A Leader’s Guide”, “Research repeatedly shows that people deliver their best effort and ideas when they feel they are part of something larger than the pursuit of a paycheck" and who doesn’t want that? Obviously for this to be the case you need excellent management, and this is where the second important point comes into it.

One of the main reasons that Mr. Hoffman says pivoting too far away from your initial business doesn’t usually turn out well, is because the company loses its edge. If a company that is originally an app developer notices that they aren’t doing very well, see’s a lot of people eating ice cream and says “I need to get me some of that ice cream money”, pivots to an ice cream manufacturer, usually this won’t end very well because the two businesses are just too dissimilar. App developers don’t usually have the knowledge and experience to run an ice cream manufacturing plant, which on the face of it is exactly what SOP did. Originally a miner, then unsuccessfully tried to become a Asian property developer and ended up becoming an engineering firm, neither of these are remotely close to SOP’s original mission. But the purchase of Synertec came with an ace up its sleeve, that aces name is Mr. Michael Carroll. Mr. Carroll stayed on after the acquisition and now sits as Managing Director, bringing with him over 23 years of experience running Synertec. 

“But is Mr. Carroll the type of manager who is able to take the new vision and reinvigorate everyone?” I don’t know him personally and have never meet him, but a quick Linkedin stalk session gives me the impression that he probably is. Within the book “In Search of Excellence”, by Thomas Peters and Robert Waterman Jr., they state that one way to motivate employees is through positive reinforcement, but more specifically, that “small rewards are more effective than large ones”. They also state that the outcome of positive and negative reinforcement is asymmetrical, whilst both nudge the employees to change their behaviour; negative reinforcement changes their behaviour in unpredictable ways, whilst positive reinforcement usually pushes them in the intended direction. For example, if an employee gives a poor presentation and you choose to criticise them, the next presentation could be good, or it could be bad, depending on the type of person you gave that criticism to. Whereas, if you where to give them positive reinforcement, highlighting the areas where they did excellently, the next presentation is more likely going to have those areas further exaggerated, which if repeated, will slowly nudge them to give excellent presentations in the future. In summary, small but frequent positive reinforcement is, according to them, an excellent way to motivate and encourage your employees. We can see Mr. Carroll displaying this type of behaviour on Linkedin, he’s three most recent comments are “Great work Jarrod - again!”, “All the best for the future Heidi.” and “A great effort by our Perth team!”(Clearly this is not the best platform to view this type of behaviour, who is going to give negative reinforcement online? But the fact that he does this, I believe, increases the likelihood that he is also like this in real life). Another way to try and see if Mr. Carroll is actually like this in real life is to view his direct reports online activity, as the old idioms go, “A fish rots from the head”, or “Shit roles downhill”, well not only does poor leadership roll downhill but excellent leadership does as well. Mr. Joern Buelter, SOP’s COO seems to have taken up this type of management style as well, with comments such as “Congratulations & well done Christopher & the Senversa team!” and “Congratulations!”, seen in his Linkedin activity. They also have a score of 3.3 out of 5 on seek, not a bad score given that there is only 4 reviews so far (not the best sample size) and people usually only take the time to give a review when they are disgruntled.

Great management is extremely important, but if the sales team are unable to bring in orders, than it’s not really worth much, there’s no point in having a well managed team with no work to do. They have however done an excellent job bringing in new work since they listed, as I said earlier, they have signed 7 new or extended contracts for a total value of 19.26m since relisting. Along with their project work, SOP also has site proven IP in their LNG Custody Transfer system (Brochure here). These types of systems are installed to accurately calculate the volume of LNG being transferred between producers and buyers. They do this by measuring the flow rate within the pipe and simultaneously calculating the percentage of the different elements to accurately calculate the volume of LNG. Which sounds quite simple, but is in actual fact extremely difficult. Things such as pressure changes, containments or the liquid’s temperature increasing above its due point, causing it to undergo a phase transition into a gas, all need to have no effect on the measurements, accuracy is crucial given the massive potential loss if the system isn’t working correctly. According to the Gas Processing & LNG site, “a one percent error in LNG transferred can equate to as much as a $600,000 to $800,000 AUD in misallocation or disputes during custody transfer”. SOP’s system can combat all of these challenges, operating with a 99.98% accuracy, giving it all of the required ISO and GIIGNL compliances. To help sell their system, SOP has teamed up with Trelleborg AB, a speciality Engineering firm based out of Sweden. I’m sure this helped SOP sell their second unit to Chevron, the first being at their Wheastone LNG plant in WA and the more recent at their Gorgon LNG plant on Barrow Island. The second system was sold on the 27^th of March and completed on the 4^th July, taking a total of 13 weeks from sale to completion, pretty impressive delivery time.

The Pursuit for Baggers

As with recent articles, I will again look for the 6 similarities, pointed out by Mr. Chrisopher Mayer in his book “100 Baggers: Stocks That Return 100-to-1 and How ToFind Them”, of companies that where 100 baggers between 1962-2014.

1. Start Small

You don’t get much smaller than SOP, with a current market cap of $9.37m (share price $0.45) a FY18 revenue of $11.4m and profit of -$0.3m (adjusted for listing expense) it doesn’t really get much smaller than that. I wouldn’t worry too much about the negative profit figure, as I said earlier, profit is being postponed, they generated $0.99m in Op cash flow and as Wini suggested, if you subtract work in progress and tax from deferred income, you can see they generated ~$1.8m in cash.

2. Low multiple

As you can see from the table above, SOP is operating on a very low EV/Op cash multiple, one third of the next engineering firm (apart from EVZ). They are also operating on a low price to sales ratio of 0.87 for FY18 and a price to book value of 1.73. Unfortunately, due to the revenue recognition policy, the metrics that I normally use are of little to no use.

3. High Returns on Capital

I was unsure of how to correctly calculate the return on invested capital for SOP, the hidden earnings in FY18 and 1H19 was influencing the outcome quite considerably. I therefore have used Op Cash as the return, which as I stated earlier is quite lumpy, especially in an engineering firm. This is evident in the difference between FY16 and FY17, the huge increase in FY16 was offset by a large loss in FY17. If we exclude these two outliers, we can see that FY15, FY18 and 1H19 (which I believe is a pretty good substitute for FY19) all have a ROIC of 18%, quite a good figure.

4. Owner Operators

Mr. Carroll is one of the initial founders, having worked for SOP for over 23 years, he also owns ~45% of the company. When we add this to the other board members holdings, we find that they own a combined 49%, you don’t get management and shareholder interests much more aligned than that.

5. They have invested in themselves

SOP has spent an average of 1.2% of revenue each year on business development. Along with this, 2 years ago, they expand their operation, opening another office in Perth. We can also see that they are investing heavily in employees, having advertised for 17 high/senior level positions over the past 12 months. A number of these would be contract work for the specific projects, such as the site supervisor roles in Newcastle (Newcastle Terminal expansion project, won in Dec 2017) but I don’t think all. Especially when we see that Employee + Super costs have increased from $4.3m in FY16 to $6.2m in FY18 a 44% increase.

6. Long Time Horizon

Long time horizon is referring to the companies taking a long time to become a 100 bagger, they need time to capitalise on the good work of the past and to reinvest into themselves. Due to IFRS 15, this may take a little longer with SOP as the profit in the statements is deferred, increasing the time it will take for analysts to notice them and look further into the notes. 

SOP therefore has 5 of the 6 ingredients to be a 100 bagger, they will still need the most important one though, the ability of management to continue to find and pursue investment opportunities that generate a high return. Easier said than done.

Risks

Whilst SOP has the endorsement of a pretty big hitter and from my research is looking pretty good, that doesn’t mean it doesn’t come without risks. A big one that I am certain is having a huge influence on this thesis is the Halo effect. The Halo effect as stated on Wikipedia is “a perception distortion that affects the way people interpret the information about someone that they have formed a positive gestalt with”. It also applies to information that they publish, if you like someone, or perceive them as an expert, you are less likely to think independently, taking what they say not quite as gospel, but definitely seeing their publishing’s through rosy coloured glasses. Wini’s amazing results on Strawman would be blinding me to any flaws that I might have seen, hopefully I’m not fully blinded, but maybe just one eye J.

The number of projects that they win could decrease, either from economic conditions or poor management. I have seen, on more than one occasion, such poor handling of customers that after a project is company they are blacklisted, never to work with them again. Unlikely, but it does happen.

The custody transfer skid isn’t patented and whilst I’m in no way an expert, I couldn’t see any real advantage over other custody transfer skids. They all seem to have the same level of certifications and whilst SOP’s team would be extremely competent in the metering systems, so would all other custody transfer skid builders. This means that SOP is relying heavily on their sales staff’s ability to create and maintain relationships, which might help to explain why they enlisted the help of Trelleborg AB. I would therefore not assume that these custody transfer skids are going to be a big money earner anytime soon. If I am wrong about this or you have further insight, I would really appreciate it if you could get in contact.

Liquidity risk, this is not a thesis specific risk but a share price risk

Opportunity cost; it could take a long time for other investors to uncover the understated earnings, potentially causing us to miss out on other profitable investments whilst we wait.

Discussion

I think it’s pretty clear that I am pretty keen on SOP, but what could unlock the potential gains Wini has calculated, what could be the catalyst?

The large amount of cash currently being generated is being stock piled, which will eventually mean that they will spend it. Whether they allocate it to buybacks, dividends, internal growth or acquisitions, the fact that they are doing it will help put SOP on a large number of people’s stock screens. It might take a little longer, especially given the size of SOP, but a little advertisement will help speed that up.

We also have the power of the Wini post, this stock went from held by 0 and followed by very few, to held by 2 and followed by 27 after Wini posted about it. He is currently being followed by 609 people on Strawman and not only that but Strawman advertised this write up in their weekly newsletter which gets sent out to the ~4000 Strawman members (assuming none have opted out). That’s some bloody good advertisement.

Conclusion

SOP is a little gem, unfavourable listing, hidden profits, owner operators, proven IP, low margin; it’s the perfect recipe for an undervalued company. But that doesn’t mean that they don’t come with risks, risks that the management team will need to watch to ensure that shareholders are able to benefit from the hidden profits.

Anyway, I hope I have inspired you to start your own research and as always, thanks a lot for reading, I really appreciate all the feedback I have received so far. I am on Twitter Follow @MaysTrav and Linkedin  if you’d like to connect, feel free to send me a msg, it’s always great to meet other ASX investors, especially those who have a different view point 

Thanks for reading

Just Culture Investor

Trav Mays

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Sources:

1.https://www.ifrs.org/issued-standards/list-of-standards/ifrs-15-revenue-from-contracts-with-customers/
2. https://mastersofscale.com/
3.https://www.amazon.com/Search-Excellence-Americas-Companies-Essentials-ebook/dp/B009YM9VOQ
4.http://www.gasprocessingnews.com/features/201310/advancements-improve-custody-measurements-for-lng.aspx
5.https://www.mckinsey.com/business-functions/organization/our-insights/making-work-meaningful-a-leaders-guide
6.https://www.trelleborg.com/en/marine-and-infrastructure/products--solutions--and--services/marine/lng--custody--transfer/synertec

The author is a current owner of a portion of Synertec, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action. Please refer to Disclaimer page for a full list of disclaimers.