Applying Just Culture to improve investment decisions

Thursday, 11 April 2019

Has XRF Scientific reached an inflection point? (ASX:XRF)


XRF Scientific evaluation

11/04/2019

Trav Mays
 


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).

XRF Scientific inflection point investing

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.

XRF Scientific expenses revenue evaluation

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.

XRF Scientific segment breakdown profit before tax PBT

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.

XRF Scientific profit vs. mining expenditure

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).

XRF Scientific half year value metrics

Not only are they improving the value metrics, but they have been improving margins as well, with all margins, except gross margin, trending higher.

XRF Scientific half year margins profit NPAT gross margin

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.

XRF Scientific segment profit before tax return on assets

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.

XRF Scientific share price evaluation

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.

XRF Scientific german office profit revenue

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%.

XRF Scientific german office profit

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  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

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  
Location: Brisbane QLD, Australia

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