Scientific Digital Imaging – a (rare) lowly valued compounder #SDI
Scientific Digital Imaging – A (rare) lowly valued compounder
By guest writer Eric.
Despite the relatively small market cap of around £50m, it’s perhaps harsh to call Scientific Digital Imaging an under the radar stock. The share price is up 5-fold over the past few years as the company has embarked on a buy-and-build model as a designer and manufacturer of high-tech scientific instruments and other products. Yet today, the company’s valuation is not only at the low end of its historic range, but it remains low in an absolute sense versus the market – trading on a forward P/E of 13.4x. Versus the growth prospects on offer and the ability of the company to compound organic and inorganic growth, I think the market is (temporarily) underappreciating the SDI story, and see the current multiple as at least 20% too low (a multiple of >16x looks fairer) and with likely upside to earnings forecasts when future acquisitions are announced.
Where has SDI come from?
Prior to 2016, investors were hard pressed to find an interesting angle on SDI. The business was treading water, and profitability was uninspiring. For example, in 2015, the company posted £7m of revenue (flat yoy), and with an adjusted operating profit of £393k (a margin of 5.6%). The business at the time primarily consisted of Synoptics (scientific instruments manufacturer) and Artemis cameras (cameras for astrology and industrial applications). Cash generation was patchy, and the balance sheet did not have significant flexibility. Both subsidiaries are still part of the group, but today they’re a much smaller fraction, and critically, both have gone through significant waves of investment and innovation since 2015.
But what has really changed is the corporate strategy: a decision to embark on a buy and build model, with the main focus currently in two areas – Digital Imaging (FY19 54% of sales, built around Artemis, now Atik), and Sensors and Controls (FY19 46% of sales).
The logic around the acquisitions is relatively simple and is similar to the proven model deployed by AIM favourite Judges Scientific (or Halma, higher up the spectrum). In the private markets, there are a raft of market leaders in specific niches, often family owned, or founder controlled. As I will describe in the next section, these private businesses can be bought at significantly lower levels than public market valuations, which is a powerful engine for creating shareholder value.
What makes a good acquisition for SDI? High quality businesses with loyal, global, customer bases. High-tech/medical/scientific products. Sustained profitability. Growth potential (especially internationally), and an in-place motivated management team. SDI has historically shown a preference for small businesses, in the low single digit £-millions amount.
Once acquired, the businesses will generally operate as before, though under the SDI umbrella, with a keen eye cast to look at efficiencies, cross-selling of products within the group, and sharing of expertise. All of this combined enables a >65% gross margin and high teens percentage operating profit margin. Today, the SDI product portfolio across the subsidiaries ranges from image analysis systems to water purifiers, heat exchangers, flowmeters, electrodes, high-sensitivity cameras, chemical dosing systems, and graticules. The business operates globally; last year, 38% of revenues were from the UK, 18% from Europe, 16% from Americas, and around 25% from Asia and the rest of the world.
The simple maths of inorganic growth
SDI looks to acquire these private businesses within the 3-5x EBIT level – the market values SDI on around 12x EBIT, give or take. This leads to powerful earnings accretion and means that, alongside organic growth, SDI should be able to deliver comfortable double-digit earnings growth as it continues to execute on its strategy.
The strategy is a relatively simple equation (though harder to execute in reality) that has created significant shareholder value to date and promises to continue doing so into the future. SDI has completed numerous acquisitions (initially part funded using equity), including of Applied Thermal Control, Fistreem International, Graticules Optics, and MPB Industries, and in each case, the acquisitions have been earnings accretive.
In short, each acquisition has left the stock cheaper than it was prior to the deal, often by >5%. For example, Thermal Exchange was 9% accretive, Fistreem 7%, Applied Thermal Control 8%, Graticules Optics 6%, and MPB Industries 8%. It’s akin to a ‘trading ahead of expectations’ RNS, but in-built into the business model and with consistent logic. Add on top of that an ability to hopefully accelerate the organic growth of these businesses, and you have a stock with a business model capable of long-term compounding.
To put it into perspective, thanks to this business model, SDI’s earnings forecasts are generally on a consistently upward trend. FY20 EPS (which is their current financial year) have increased from an initial estimate in July 2018 of 2.52p, to 3.57p today – an uplift of 42%.
Forecasts and current trading
Execution of the strategy has seen revenues increase from £7m in 2015 to £17.4m in 2018, adjusted diluted EPS more than double from 1.47p to 3.02p, and adjusted EBIT margins increase from 6.5% to 17.8%. Thanks to a number of acquisitions made in the last financial year, this trend will continue in the current financial year (2020). Revenues are forecast to grow 33% to £23.2m, with an adjusted EBIT margin of 18.2%, and adjusted diluted EPS of 3.57p. Next year, forecasts are for 5% growth to £24.4m, an adjusted EBIT margin of 19.2%, and adjusted diluted EPS growth of 12% to 4.0p – a FY1 P/E of 12.75x.
Considering the prior section, the reality is that these forecasts will be mechanically upgraded as and when SDI makes further acquisitions, and they generally target at least a couple per financial year. The forecasts also have in-built organic growth of around 5%, which I’d consider to be a relatively conservative assumption (although in line with what they delivered in 2019). Crucially, even excluding acquisitions, management appear to set expectations conservatively as reflected in the trend of trading ahead statements in previous years. While they are on a headline 12.75x financial year 2021 P/E today, by the time we get there, I suspect we’ll be closer to 10.5x – 11x.
Current trading is solid. An AGM trading update was released in late September highlighting that “the group has made a good start to the new financial year … the board is comfortable with current trading and in delivering financials in line with market expectations for the year”, which are the £23.2m of revenues, and adjusted EPS figures of 3.57p highlighted previously.
What are the risks?
The clear risk for SDI is that they make an error in their acquisition trail, and that’s certainly one investors should bear in mind. However, the strategy is proven, and the acquisitions are small. In addition, SDI has reached the critical mass so that it is not only searching out its own bolt on acquisitions but also has third parties reaching out to it. All considered, that means the company can be extremely selective. CEO Mike Creedon comes across very competently, as also reflected in the substantial step up in the market valuation of the company and the market’s perception of the stock.
The other related risk would be that the company takes on too much debt – an accusation I could levy at Victoria PLC. The management team at SDI is relatively conservative, and the highly cash generative nature of the business is strong protection again. Net debt at the end of the last financial year was £1.6m (vs. market cap of £50m) – on neutral working capital, cash generation capacity would be expected to be around £3.5m this year.
13.4x P/E valuation looks anomalous
Despite the significant share price rise, the valuation still looks anomalously low. The current P/E of 13.4x is versus the stock’s peak valuation over the last year and a half of around 18x, and versus the trough over the same time around 12.7x. As such, it is trading towards the lower end of the range, and slightly above 50p. Although Judges Scientific has a longer track record of delivery, continued outperformance there has seen the share price jump 75% year to date and trade at around 20.6x P/E. Forecasts at Judges are for around 4% growth next year (pre any acquisitions) and a 20% operating profit margin – not at all dissimilar to SDI. The valuation at Halma is even punchier though more aspirational than achievable – 6% organic growth, 21% operating profit margin and 29.9x P/E.
Part of the reason likely relates to a buyer strike around Brexit (though no-deal Brexit aside which probably hits most physical good stocks). The other part is, in my opinion, still some nervousness around looking at the forecasts and seeing a big step up in growth. Investors are naturally a lot more comfortable looking at a high valuation in the rear view than in the front view. The good news, in my opinion, is that forecasts here are significantly derisked by the September trading update, but moreover, the forecasts only incorporate 5% organic growth – much of the growth is purely mechanical from the acquisitions. What this does mean is that the interim results (due December) should make pleasing reading given that this growth is pretty much in the bank.
A not unrealistic target would be for SDI to do two acquisitions before their year end next April, and for them combined to deliver 10% earnings accretion. That would point to 4.4p of EPS in their next financial year 2021. A 16-17x multiple (mid to higher side versus last 18 months’ multiples) on that would point to a share price of 70p to 75p, or upside of 37% to 47%. Continued execution by the management team should tip the balance towards that target being very realistic.
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