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.  

Learning from Laserbond (ASX:LBL)

02/07/2019

Trav Mays

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LaserBond (ASX:LBL) recently hit an inflection point, after some excellent management decisions and some tailwinds, shareholders have been rewarded with a 244% gain over the past year. Today we will be investigating if there are gains still to be made and to see if there is anything we can learn.

LaserBond first come to my attention whilst researching XRF Scientific (click here for that post). A number of excellent articles, such as Mr. Joshua Baker’s on Livewire titled “A platinum crucible in the rough”, compared XRF to Laserbond. So ever keen to learn more, especially about inflection point investing, I decided to dive deeper to see what nuggets of knowledge I could uncover.

Company

LaserBond, originally called HVOF Australia P/L, was founded by Mr. Gregory Hooper (Currently Executive Director) in 1992, working out of a small workshop in Ingleburn NSW. (HVOF stands for High Velocity Oxygen Fuel, which is a type of thermal spray system that uses combustion to heat and propel particles near supersonic speeds. These high flying particles collide with a material, forming an extremely high density low oxide coating.) Gregory’s brother, Mr. Wayne Hooper (Currently Executive Director) joined HVOF in 1994 and together they were at the forefront of laser cladding innovation, building one of the first high-powered cladding systems using a 6kW CO² laser. In 2007 they listed on the ASX and changed their name to LaserBond Limited, listing for $0.2 per share and a market cap of just over $13 million.

The capital raised from their listing was quickly put to use, they invested in R&D and purchased Peacheys Engineering in Gladstone Queensland for $3m in 2008, as an attempt to capitalise on the growing gas industry. Unfortunately for LaserBond, the Queensland division wasn’t able to get any traction, the global financial crisis hit and then the large increase in activity within the Gladstone region pushed both rents and employee expenses up immensely. After a number of bad results, in 2013 they sold off 5 large pieces of equipment and their order book for $750,000, ceased all machining and fabrication work within the area, moved a number of other pieces of equipment to NSW and continued to do surface engineering work for the region from their NSW premises.

 

Whilst the Queensland division wasn’t doing very well, the rest of the business was, in fact they were doing so well, they had to move their NSW facility from the original workshop to a larger facility in Smearton Grange, just to keep up with orders. Not only that, but after 12 months of trials, LaserBond had signed a Memorandum of Understanding (MoU) with Gearhart United, within which, Gearhart committed to exclusively commissioning LaserBond for all their laser cladding work. To accommodate this large influx of work (estimated at the time to increase revenue by $1.2m, a 12.75% increase to FY2013’s revenue), LaserBond established a South Australian branch and to ensure the success of this branch, Mr. Gregory Hooper was later relocated to head it up (October 2014). Whilst the business was doing well, it wasn’t enough to compensate for the Queensland divisions loss; in 2013 LaserBond wrote off the remaining $3.6m in goodwill and posted an adjusted Net Profit after Tax loss of $0.72m. 

It was shortly after all this (February 2014) that the chairman, Mr. Timothy McCauley decided to step down. Having started back before LaserBond had IPO’d, he had done an excellent job during some extremely difficult times. Mr. Allan Morton was appointed his successor in March 2014, which in my opinion, is when the seeds for the 2018 inflection point were planted.

Mr. Allan Morton an Engineer by Trade, obtained his Bachelor of Mechanical Engineering from the University of Technology in Sydney, later going on to obtain an MBA from Harvard Business School. Prior to starting at LaserBond, Mr. Morton had worked as an engineer at CSR and successfully moved up the ranks to the operations manager role. After this he worked at a number of companies in high executive roles and/or founded a number of his own companies. Not of any real importance but interesting nonetheless, he worked for 3 years as a general manager for a company called Quickflix limited, which had the very same idea as Netflix. Having started out as a company that shipped the latest DVD’s and Blu-ray’s through the mail (they still do this), they have evolved into a streaming website, offering all the latest blockbusters, on a subscription basis, either online or via the mail! I had never heard of these guys and I am not sure if they are still operating, as they delisted from the ASX at the start of 2017, but their website is still up and running and it looks like they have some new movies on there, so it looks promising. Might be worth checking out if you are looking for another subscription or have had enough of Netflix. Anyway, one very interesting and relevant role he had, was as a founding partner of Waypoint Strategies (Founded in 2010), a consulting group that specialises in turnarounds. Which is just the type of manager LaserBond needed at this time in its history.

LaserBond started off as an innovator at the cutting edge of the surface engineering industry, they had however become complacent, drunk on the profits from the mining expansion, they had taken their focus off the company’s vision, “To be a global leader in the research, design and implementation of advanced surface engineering technologies”. This is clearly seen in their R&D spend below, after spending $0.57m (16% of revenue in 2007), the R&D spend for the 5 years between 2009 and 2013 was reduced to almost nothing, with 2013 actually being $0.

Mr. Morton came on board and changed all that, with the following couple of years reading straight out of a turnaround play book. Having divested the unsuccessful QLD branch, they reduced expenses (they implemented Lean Manufacturing in 2014), they focused on organic growth and started to reinvest in themselves, more specifically, the core of the business, its research and development department.

LaserBond kicked a lot of goals over the next couple of years, so to keep this post short, I have condense them to dot points:

• Feb 2015: They created a new class of Down-the-Hole (DTH) hammers and associated drilling components that last 2.44 times longer than the average DTH hammer, which equates to a 7% saving on the total drilling cost.
• The lean manufacturing techniques they implemented in December 2014 improved the 2HY 2015 gross margin of the NSW division from 49.3% to 53.2% pcp.
• April 2015: DTH hammers begin testing in European geothermal wells
• July 2015: Laser bond splits into three divisions, Services, Products and Technology. The Services division continues their core surface engineering work, the Products division to continue to manufacture specialised products and the Technology division to oversee the licensing of its technology to non-competitive international markets.
• October 2015: Lodged two international patents on a ground breaking laser cladding process, using the laser deposition method
• FY2016 Increased investment in themselves, more specifically employment, Advertising and research and development
• May 2016: Entered an agreement of collaboration with the University of SA
• August 2016: Awarded $3.22m over three years from the Commonwealth Government to fund the design, building, installation and commission of a dual robotic multi-axis handling system, which included a 16kW laser.
• September 2016: Enters first technology licensing contract with a crushing equipment manufacturing company in China. LaserBond is to deliver a turnkey package with all work done in-house from design to commissioning for $1.45m. The contract also includes 5 years of training and support, in return for a revenue based fee.
• February 2017: Awarded $2.616m as part of a three year collaboration with the University of South Australia and Boart Longyear (total govt fund $8.266m) to extend wear life of critical pieces of mining equipment.
• February 2017: Signed a non-binding strategic partnership to pursue mutually beneficial commercial products and services with Boart Longyear
• FY2017 report: Products division became profitable

Other includes R&D and Technology divisions

• September 2017: Mr Allan Morton steps down as Director
• August 2018: Signed a Technology licensing agreement with a UK multinational engineering company
• December 2018: LaserBond breaks into the US Steel Industry market with their Composite Carbide Steel Mill Rolls, which typically deliver 5 to 15 times the life of a standard roll.

All of this laid the groundwork for the huge increase in earnings per share for the first half of 2019, see above. Before I go into my evaluation of LaserBond, I would like to take a moment and see if there was anything that should have stood out, in the hopes of spotting the next company about to hit an inflection point.

The Pursuit for Baggers

LaserBond’s share price ,after hovering around the mid-teens for the past couple of years, exploded around the mid of 2018, gaining 244% between the 24/06/18 and 17/02/19.

I for one didn’t see this coming, but that doesn’t mean others didn’t, take the person who goes by the handle Wini on Strawman.com (If you aren’t familiar with Strawman.com, I highly recommend you check it out, excellent source of investment ideas and you get to see what some beasts of the investment world, such as Wini are currently interested in. Think of Hotcopper without the trolls), this person literally posted about LaserBond three days before it started its climb, Talk about timing!

So what should we be looking for? Mr. Christopher Mayer in his book “100 Baggers: Stocks That Return 100-to-1 and How To Find Them”, studied all of the stocks that where at least a 100 bagger (when you see bagger after a number, in this case 100, it is referring to a return of 100 – 1, I think it was coined by Peter Lynch, feel free to correct me if I’m wrong in the comments) between 1962 – 2014, of which he found a total of 365 that weren’t tiny to begin with. He then investigated these 365 companies further, in the hopes of finding commonalities and found that they all had some if not all of the following 6 ingredients.

1.       Start small (but not too small, median sales figure was ~$170m)

2.       Low multiples preferred

3.       High returns on capital

4.       Owner operators

5.       They invested in themselves and

6.       Long time horizon; compounding

So I thought it would be fun to explore each of these six to see which, if any LaserBond had leading up to the huge increase in share price.

1.       Start Small

LaserBond in 2018 generated $15.6m in revenue, a profit of 1.25m (excluding the inventory write-off) and had a market cap of $12m, so they had the first characteristic covered. Revenue and profit both had been increasing since 2015 (2016 profit decreased due to their large investment in themselves) with HY2019 alone producing $10.5m in revenue and $1.2m in profit. They have a goal to increase revenue to $40m within 3 years, still a long way to go, but there have been some quite encouraging developments recently. After taking a large dip in 2016, their profit margin has returned to their historical average of the high 7s and in HY2019 had actually increased it to 10.8%.

2.       Low Multiples preferred

Starting from a low multiple gives any earnings growth an extra boost to the share price. As opposed to starting from high multiples, where a slight decrease in the earnings growth rate, can place 2 downward pressures on the share price. Starting from a low base helps to slingshot the share price higher. It’s like an alley-oop in basketball, the increase in the growth rate puts up the shot and the increase in the multiple slams it in the net.

In 2017-2018, LaserBond had a P/E of around 10, a price to sales of less than 1 and an EV/EBITDA of around  5, all values that a typical value investor would purchase the share. This is especially true if you are a fan of Tobias Carlisle as he says an EV/EBITDA score of 5 or below is cheap, not quite as cheap as the deep value stocks he typically looks for, which have a score of 3 or less, but a cheap stock nonetheless. If we look back to 2014’s values, we can see that they are very similar to those seen in 2017 – 2018, which makes we wonder if I had of bought at this time, would I have continued to hold for those 4 – 5 years, especially with the 2016 drop in earnings?

3.       High Returns on Capital

High returns on capital is about the quality of the business and management’s ability to find and execute projects that generate high returns. Clearly to get a return of 100 – 1 the company will need to be able to generate good returns on capital over a long period of time. There are a number of ways to calculate returns on capital, I prefer Returns on Invested Capital (ROIC) and as you can see above, LaserBond has been able to generate quite high values in recent years. The same can be said about their Returns on Assets (ROA) and their Returns on Equity (ROE). So again, they have this one covered.

4.       Owner Operators

A leadership team that conducts its self as an owner operator is far better at creating shareholder value than a team that is purely motivated by money. This is because by motivating the executives with purely monetary gain, you are essentially shifted the focus from the longer term projects that produce real and lasting shareholder value to the short term goals that bring about no shareholder value but ensure the executives are hitting their KPI’s and receiving their bonuses. If you have ever had a side gig or run your own business, you know the difference you feel about the work when you are doing it for yourself, as opposed to doing it because you are paid.

One way to look for an owner operator leadership team is to look for companies that are still being run by the founder. LaserBond was no longer being run by the founder, he had been put into a position that better suited his skills, as the head of R&D, but his brother, one of the original company employees was still running it.

Another way to see if the executives are shareholder focused is to see if they own a large percentage of the company, this way, both shareholders and executives gain when they generate shareholder value. LaserBond’s executive team at the time owned 23 – 24% of all outstanding shares, with the Hooper brothers making up the bulk of the owner ship. This is very encouraging.

5.       They invested in themselves

LaserBond, after a couple of years of neglect have been continuously investing in themselves since 2014, with another big investment in 2016. The fruits of which can clearly be seen.

6.       Long Time Horizon

This one has to do with it taking a long time to reach a return of 100 – 1 as it takes time for the company to capitalise on its previous good work and then build on it and capitalise and then build on it and over and over. Clearly LaserBond have done well to continue to build on the momentum they started back in 2014, with the share price now showing a more realistic valuation of the company than in the past.

Mr. Mayer’s research emphasises the power of small cap value investing, look for well run small companies, that are currently mis-priced (low multiple), with a management team that is aligned with the same goals as the shareholders and hang-on through all the ups and downs, simple J (Disclaimer: I don’t believe you should buy a company and just hang on, if you see changes to the fundamentals and/or the story has changed, a re-evaluation is needed). LaserBond was this type of company in 2017 and 2018. I think this is one that a typical value investor would have purchased if they had turned over the right rocks, it’s just a manner of overturning enough rocks until you find one as good as LaserBond. Easy to say in hindsight, I know, but it doesn’t help to beat yourself up over missing a stock.

Evaluation

LaserBond is a great company, well run, good returns on capital and have had some large wins in recent times, most notably their expansion into the American Steel industry, but that doesn’t mean that they are currently miss-priced enough to warrant purchasing.

LaserBond has stated on a number of occasions that they are aiming to generate $40m in revenue within the next 3 years, using this, their NPAT margin and the trailing 5 year EV/EBITDA multiple we can try and approximate a figure the market would place on this result. LaserBond in 2018 had a EBITDA margin of just 14.3%, they have however said that they are working on increasing this margin (it was 17.9% in 2017), so I have instead used 16%. I have also increased the number of shares using the past 5 year growth rate and also used the trailing 5 year EV/EBITDA multiple of 7.5. As you can see below, if they are able to achieve their revenue goal of $40m and the market assigns a historical margin, we are looking at a 9% gain on today’s prices, 5% if they miss it by 10% and 14% if they exceed it by 10%. If they instead assign a multiple of 10, we are looking at gains of 20%, 26% and 33%, respectively.

Whilst I have calculated that the share price is currently between priced about right and a number that I believe doesn’t offer enough of a safety margin for me to purchase, I am reminded of Matt Joass article on inflection point investing, where he explains the human brains inability to extrapolate anything other than linear forecasting very well, see below. 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.

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

Conclusion

Mr. Morton did a great job helping to refocus LaserBond on their core business, the results of which are clearly beginning to bear fruit. They have divested the non-profitable parts of the business and grown organically whilst reducing expenses and have achieved a HY2019 EPS just shy of the EPS produced for FY2018. I do however believe the market has repriced the company about where it should be, given the recent developments and their growth. They did generate $10.5m of revenue (45% increase pcp) in the first half, but given that their revenue is close to 50% first half 50% second half, they will still need to double that in both halves before they reach $40m revenue, not an easy task, but definitely achievable.

I set out to do this post to try and learn from other people’s successes. Instead it has reignited my belief in value investing, but at the same time, emphasised the need to look for companies going through inflection points. Missing a small percentage of the upside is better than purchasing and holding out for years in the hopes the market might see the mistake it has made. It has also shown me that I need to spend more time on Strawman watching what other great investors such as Wini are doing, reading their reviews on companies and learning what I can from them.

Whilst I missed the ship with LaserBond, it’s great to see that there are potentially still mispriced companies out there, especially given how long this expansion has been going on for.

If you liked this and would like to read more, I have started working on a series about inflection point investing, read my first post about XRF Scientific here, the second post about Korvest here, the third about Paragon Care here and don't forget to subscribe, so you don't miss out on my upcoming posts. 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.livewiremarkets.com/wires/a-platinum-crucible-in-the-rough

2.       https://www.amazon.com/100-Baggers-Stocks-100-1/dp/1621291650

3.       https://www.waypointstrategies.com.au/

4.       https://www.quickflix.com.au/

5.       www.Strawman.com

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

The author is not a current owner of a portion of LaserBond, they may however still 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. The author could change their opinion on any of the holdings at anytime and are not under any obligation to update the website if/when this occurs.