Has XRF Scientific reached an inflection point? (ASX:XRF)
11/04/2019
Trav Mays
Follow @MaysTrav
XRF Scientific performed exceptionally over the half year, posting a profit greater than the FY2017 and FY2018.
After a tough couple of years, they have reached an inflection point, read on
to find out more.
Inflection Point
After reading Matt Joass’ article “The HiddenPower of Inflection points”, (If you haven’t already, I highly recommend
you read Matt’s article and subscribe to his website, keeping you up to date
with the writings of a man who has achieved quite amazing results) I have been
on the lookout for a company that could be passing an inflection point. XRF Scientific appears to be just such a
company.
An inflection point, described by Investopedia as “an event
that results in a significant change in the progress of a company, industry,
sector, economy or geopolitical situation and can be considered a turning point
after which a dramatic change, with either positive or negative results, is
expected to result”. Matt within his article, goes on to name a number of
different types of inflection points, luckily for us, he describes the
turnaround first, which in my opinion, is where XRF are currently at. If you
have read my thesis on The Reject Shop, you’ll know that I’m not a big fan of turnarounds, extremely
hard to predict and as Peter Cuneo stated in an interview with Forbes “9 out of 10 turnarounds are
not successful”.
As you can see on the graph below
(borrowed from Matt’s article), purchasing at the inflection point typically results in a % of
the gains being missed. But as value investors, we typically would have
purchased somewhere along the initial price
decline. How long it takes for a company, if at all, to turn back around is
dependent on the situation. We could therefore be waiting years for an
inflection point, with the share price continuing to trend down. Hopefully we
have been averaging down during the price decline, but you need a lot of
conviction to do this and I have definitely fallen victim to not believing in
my valuation and selling out before the inflection point. Having said that, I have
also held on too long, only to finally have my eyes opened to the mistake I
made far too late. Blasted anchoring and confirmation biases! (Read about an
example of this here).
The benefits to such a style of investing really resonates
with me and not only that, it has some heavy hitters using it. Howard Marks
wrote this in his memo titled “Dare to be great II”, “Being too far ahead of your time is
indistinguishable from being wrong. The fact that something’s cheap doesn’t
mean it’s going to appreciate tomorrow; it can languish in the bargain
basement. And the fact that something’s overpriced certainly doesn’t mean it’ll
fall right away; bull markets can go on for years. As Lord Keynes observed,
“the market can remain irrational longer than you can remain solvent.””
Not only will purchasing at an inflection point reduce time
induced errors, but it has a record of performing exceptionally. A strategy
using both value and momentum was one of the best strategies within Jim
O’Shaughnessy’s book “What Works on Wall Street 4th edition” (named the trending value
portfolio in the book). It achieved a geometric average return of 21.19%
between 1964 and 2009 (45 years). Not only that, it had a Sharpe ratio of .93
and bested the All Stocks index in 99% of all rolling 3 year periods and 100%
of all 5,7 and 10 rolling year periods! Absolutely amazing results. To achieve
this, Mr. O’Shaughnessy screened out the top 10% (Decile 1) of the all stock
index, using 6 value metrics (P/B, P/E,P/S, EBITDA/EV,P/CF & Shareholder
yield) and from these he selected the top 25 stocks with the highest 6 month
price appreciation. By using this strategy, he inadvertently (I’m sure this was
his goal or at least part of it) selected companies that are on their way to
recovery or saying it another way, were at or near their inflection point.
Reading Matt’s article for me was an "Ah Ha" moment, putting a
whole lot of pieces together and completing the picture. Anyway, I digress, you
clicked here to read my analysis on XRF Scientific, so here it is.
Company
XRF Scientific (ASX:XRF) is an Australian listed, Perth
Based, scientific equipment and chemical manufacturer with support facilities
in Perth, Melbourne, Europe, Canada and a global distribution network. They
operate using the razor blade business model, whereby they sell the scientific
equipment at a low margin (2018 PBT margin 7%) in order to increase sales in
their high margin (2018 PBT margin 27%) consumables division (margins can be
seen in the evaluation section below).
XRF breaks their business down into three segments, Capital
Equipment, Precious Metals and Consumables. The Capital Equipment segment
includes the design, manufacture and service of specialised fusion and
laboratory equipment, whilst the Precious Metals division manufactures products
for the platinum alloy markets and the Consumables segment producers and
distributes chemicals and other supplies for analytical laboratories.
Discussion
Within Peter Cuneo’s Forbe’s interview, he states that “there are three elements to a
successful turnaround, cost cutting, organic growth and strategic leaps”. I
believe that XRF has either achieved, or are on their way to achieving all three.
As you can see below, XRF since 2016 has been reducing their expenses as a
percentage of revenue, whilst simultaneously increasing their revenue (64% gain
in revenue between 2015 and 2019). They have also increased their profit margin
whilst keeping the gross margin steady at 39% (See table in Evaluation
section), that’s the first two elements covered.
What about the strategic leaps? Well XRF’s expansion
(strategic leap) in the Precious Metals Division is beginning to bear fruit.
The plan, originally announced in October 2015, was to expand the Precious
Metals division into the overseas market, with the first step being a new
Melbourne manufacturing factory with upgraded equipment; the investment
totalled $3.3m. The added production capacity allowed XRF to open their first
European office in Germany, working as a distribution hub for the European
market. The German office has recently record their first profit, $5k in
January 2019, with XRF predicting it to produce a “material impact” to the
group’s profits within the next 1 – 2 years.
When we look at the individual segments profit before tax,
we can see that both capital equipment and precious metals got hit pretty hard
in 2016 and 2017. These results were from a combination of factors, the new
German office, the relocation of the manufacturing facility, lower investment
in mining, uncertainty around the US election, and an increasing in lithium
prices.
The slowdown of the investment in the mining sector hit XRF
especially hard, see below, as the mining sector accounted for 70 - 80% of
XRF’s profits at the time. They have since reduced this to 58%, helping to diminish
the impact of mining’s cyclical nature.
Whilst the profit before tax has been trending upwards in
recent years, this is not a result that has come purely from exceptional
management; they have had some tail winds. One such tail wind is the reduced
price of lithium, as a component within some of the consumable products, this
decrease helps to lift margins. Another has been the increase in mining
expenditure in plant and equipment in recent years. Along with those tail
winds, XRF has spent just over $3.44 million on acquisitions over the last 6
years, clearly this along with the tail winds stated, have been helping fill
XRF’s sails.
Evaluation
Looking at XRF’s half yearly metrics, it’s clear that they
have been improving on all fronts since their disappointing 2016 result. As an owner,
we are currently getting a larger slice of the revenue and profit for our
money, not only that, but XRF is currently running the business better, both
Return On Assets and Return On Equity are trending higher. Along with this, for
the first half of FY2019, XRF has achieved a Pitroski score of 7 (not within
the table), losing points for the current ratio being lower than 2017 (2.64 HY2019;
2.98 HY2018) and Gross margin not being higher than 2017 (39.2% HY2019; 39.4% HY2018).
Not only are they improving the value metrics, but they have
been improving margins as well, with all margins, except gross margin, trending
higher.
Breaking it down further into
segments, you can see that the Profit Before Tax margin along with the ROA’s is
trending up for all 3 segments.
To come up with an evaluation of
XRF, I have assumed that there is no growth within the second half of 2019, they have generated 50% of the FY EBITDA within the first half (48.6% 2018 & 47.7% 2017), and
have used the average EV/EBITDA margin from the last 6 years. This gives us a share
price of $0.24, a 42% gain on the price at writing.
Is the no growth in the second
half of FY2019 a reasonable assumption, I don’t think so. As you can see below,
the German office has been increasing their revenue per half consistently over
the last 2 years. Along with this, there has been a revived growth in mining
activities across the globe and the (hopefully) continue negative trend of the
lithium price. I therefore believe that the share price of $0.24 is conservative, given this and the already 42% gain, I believe that XRF
scientific will make a great addition to my portfolio.
Whilst not affecting the above analysis, but something to
keep in mind is that not only is the German office increasing revenue, they are
improving the bottom line as well. In the first half of 2019, the German office
made a total contribution of -$247,152, but then went on to make their first
profit in January 2019; $5k. I don’t think that they will necessarily make a
profit for the whole of the second half when looked at alone, but when the
benefit to the other XRF divisions is added to it, I believe if it doesn't break
even, it will be very close. The progress the German office has been making to get to breakeven over the last 2 years helps confirm this assumption. Below, I
have graphed the German office profit along with the % change. As you can see,
they decreased their loss in 1H 2019 by 34% pcp, to achieve this, they
increased revenue by 43% whilst expenses only grew by 18.5%.
Conclusion
XRF appears to be at an inflection point, they have
diversified themselves from the mining industry, expanded to a larger
manufacturing facility, opened a German distribution hub that has just become
profitable, increased profit margins across the board, increased revenue,
reduced expenses, have taken strategic leaps and just posted a half year
profit, higher than FY2017 & FY2018. All this and they are currently trading
at lower market cap than the last 6 years. Peter Cuneo said “there are three
elements to a successful turnaround”, XRF, in my opinion, has achieved all
three. 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.
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.
Sources:
The author is a current owner of a portion of XRF Scientific, 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
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