Somero Enterprises (SOM) – Flat floors matter (apparently!)
Somero Enterprises makes the machines that enable builders to deliver flat, concrete floors. Exciting stuff. The obvious question is: to what extent is a flat floor a must have for builders and occupiers? I had a chance to put this Jeremy Paxman level of interrogation to Somero management on September 11th.
The question I asked is whether warehouse robots and staff would fall over on an uneven floor. Robots tripping up would be useful if there is ever a robot uprising of the type seen in the Terminator 3 movie.
The answer as to why flat floors matter stems from the main customer base for Somero. The rise of e-commerce distribution centres and warehouse facilities has made flat floors all the more important.
Getting a flat floor with Somero’s equipment
A typical e-commerce warehouse will have very high stacking shelves; think of the Ikea warehouse as you leave the store. The warehouse trucks have to be able to operate safely when loading and unloading goods.
The trucks are typically whizzing around the stores at the same time that they are lifting or lowering goods. A bump in the floor may not have negative consequences for efficiency, and for anyone standing underneath one of the moving trucks.
I also asked whether the e-commerce companies are demanding flat floors from their real estate landlords. This should be a major demand “pull factor” not least in fast growing countries like China and India.
However, Somero currently generates two-thirds of its revenue from the United States. Europe accounts for 15% of revenue and China generated only 5.5% of group revenue in the six months to 30 June.
The Rest of World segment includes Australia, India, Southeast Asia, Scandinavia, Korea and Russia and generated only 8% of group revenue. Can it really be the case that people outside the US aren’t interested in flat floors?
Management were quizzed on the weak demand in China and apparently the building standards are relatively low. The group recently hired a Chinese national as a sales director for China and believes there will be an improvement in the second half.
With regard to Europe the explanation was that European builders take care of Somero’s machines and make them last longer. The bottom line is that Somero has, to date, been a US success story rather than a global success story.
Somero share price since 2016 IPO: back in business
Source: Google Finance
The growth “roadmap” for Somero is based on 1) international expansion and 2) product innovation. The vast majority of new hires for the business since 2007 have been outside of North America.
Somero started as a single product company in 1986 and currently has 13 “innovative products.” The group also currently has 62 patents and patent applications covering its product portfolio.
The latest product to be developed is the S-22EZ (November 2017), which is described as an “Advanced Laser Screed.” This is apparently the hottest product right now in the world of flat flooring.
It is also worth noting that flat flooring isn’t only something that is demanded by warehouses. Multi-story buildings also require flat floors with Somero’s equipment helping to speed up construction and reduce labour costs.
International expansion can be viewed as risky but Somero has an innovative way of ensuring payment. My understanding is that company’s machines have a remote kill switch that the group activates when a customer “forgets” to pay.
Keeping the competition at bay is critical for a business like Somero. Rivals first tried to reverse engineer its products shortly after the group started. However, Somero has kept rivals at bay through a number of competitive moats.
They include customer support, education, training, spare parts delivery and availability. A hold up in the building work for a site is very costly and Somero states that: “the concrete floor is the most critical component of any building.”
Product innovation and the patent portfolio will also help to keep competitors at bay. The key, though, is that construction companies will generally prefer to use a reliable brand given the importance of getting a concrete floor right the first time.
My efforts at scuttlebutt in this area have been limited to a discussion with a builder at Wheeliedealer’s recent pub bash. The builder in question confirmed that Somero’s equipment has a strong reputation within the industry.
Financials: do you remember the downturn?
Turning to the small matter of the financials and Somero is a profitable business but is also subject to cyclical demand. The operating profit margin has increased from 21.2% in 2014 to almost 30% in 2017.
These are relatively fat margins and in 2007, before the financial crisis, the group earned a 20% operating margin. However, a fall in demand saw Somero fall into losses in the three years from 2009 to 2011.
Somero had a cash position of US$20.7m at mid-2018 and is therefore well placed to weather future downturns. The group will still, though, suffer if there is a global downturn or if the US economy experiences a major setback.
Somero through the last economic cycle
Outlook and valuation
The outlook statement is where investors immediately jump to when results are released. The exact wording is carefully analysed versus the language that has previously been used.
Jack Cooney of Somero stated alongside first half results that:
“Based on our H1 2018 performance, the momentum of the business carrying over into H2, and healthy market conditions across our footprint, the Board expects Somero to deliver another successful year of growth in line with current market expectations.”
Looking further out and new product development is expected to drive long-term growth. The US economy is clearly doing well at the moment but demand for Somero’s products will slump in the next downturn.
The shares currently trade on a rolling forecast P/E of 14X and offer a dividend yield of 4.7%. Free cashflow per share has been close to earnings per share for the last four years and net cash is around 6.6% of the current market valuation.
If Somero can start making progress in China this year then shareholders may reappraise the investment case. E-commerce and general warehouse users should, in theory, be crying out for flat concrete floors.
Would I buy Somero? The trouble with cyclical stocks is that you have to take a view on the economic cycle. Somero is a very profitable and e-commerce warehouse demand may be a secular driver. The shares merit further research in my view.
Optional reading: further financial analysis for geeks!
This section is for those of you who like your financial ratios and a bit of additional analysis. Two key ratios to look at for stocks are the return on capital employed (ROCE) and the cashflow return on capital invested (CROCI).
ROCE gives you an idea if a business is generating an adequate return (accounting profit) on the capital invested. CROCI gives you an idea if the company is generating free cashflow on the capital that has been invested.
A ROCE above 15% is considered to be good while a CROCI above 10% is considered to be good. Both ratios were around 25% for Somero in 2006 and 2007, before the financial crisis hit demand.
It is interesting is that CROCI was only negative in 2009 while ROCE was negative from 2009 to 2011. Somero therefore only had one year of negative free cash flow during the financial crisis implying that the group was able to cut back on spending.
It is also interesting that Somero’s recent ROCE and CROCI figures are much higher than before the financial crisis. Somero had an impressive ROCE of 52.8% in 2017 while the CROCI was 36.5%.
1) Somero has become more profitable since the crisis
ROCE can be broken down into the capital turnover ratio multiplied by the EBIT profit margin. The capital turnover is the amount of revenue that each pound invested generates and the EBIT margin is EBIT profit as a percentage of revenue.
If either the capital turnover ratio and/or the EBIT margin increases then the ROCE will also improve. We can see below that the ROCE improvement in the business has been driven by both of them increasing.
The most recent EBIT margin is 31% versus 21% in 2006. The capital turnover ratio is just under 2X when it was close to 1X in 2006. Somero has therefore become a more profitable business and may be slightly more resilient.
2) ROCE drivers: EBIT margin and ROCE
What is impressive to me is that Somero is very cash generative with free cash flow per share close to earnings per share. Somero therefore doesn’t have to invest a significant amount of incremental capital to grow the business.
The quality of Somero’s business therefore is good but investors clearly have to factor in the cyclical demand profile. If the business can expand outside of the US then it will be better placed to offset a downturn in any one region.
3) Somero earnings per share are backed by cashflow