SDI Group (SDI): Small Caps Life verdict

[Diogenes]

A guy on the SCL discord channel - DangerCapital - has put out a fairly negative reaction to SDI’s latest results. But, as with a lot of these guys who go into micro analysis, I wonder just how much thought he puts into it. For example, he comments that the results don’t show many signs of “operational gearing” (when did that term come into vogue?) and he treats it as a runrate business. To which I would argue that it is a serial acquirer, so the group changes shape from period to period. To make like-for-like comparisons from period to period is a bit naive. And, given that it is an assemblage of businesses with different cost characteristics, should you be expecting “operational gearing”? Shouldn’t you evaluate it more like an investment trust and try to judge how well the group is allocating capital?

On the other hand, since the share price is the assemblage of investors’ opinions on what it should be, the question then becomes how much weight does a tipster or commentator bring to bear on the share price?

[Ben123]

Hi Diogenes,

Maybe I should have posted the below on an SDI company board - apologies if so.

Hmmm - based on what you say I am not sure he understands the business model.

Also, why would ‘operational gearing’ always be a good thing? - When revenue drops it’s definitely not a good thing! I’ve learnt that lesson!

To me, SDI are a group of related but independent niche business with intellectual barriers to entry which result in high returns on capital, and consequently a lot of cash generated to fund similar acquisitions in the future, without material debt on the balance sheet. Rinse, repeat. That’s the business model in a nutshell. Maybe this doesn’t appeal to the man from a place called DangerCapital - too straight-forward and (hopefully) predictable!

(edit - I’ve since learnt that ‘DangerCapital’ name has an element of irony to it and the name is related to judicious risk taking - sincere apologies to Mr Simpson)

From SDI’s full year presentation:

The strength of our business model:
• Federated structure for rapid but nuanced response
• Profitable & cash-generative businesses able to
withstand external shocks
• Diverse portfolio of companies not relying on a
single sector or region
• Exposure to future-proofed sectors
• Resources to invest for organic and acquired growth
as opportunities arise

Net debt at 30/4/21 was £1.8m with free cash flow for that year of £8.7m. That’s after 13 acquisitions since 2014.

Allocation of capital has been very good by the group, in my opinion, and that seems to me to be why it has been successful. SDI don’t need operational gearing to succeed. They just need to keep returns on capital steady or increasing slightly, by making good purchases, and gaining synergies through shared central functions, if possible.

The only dubious thing about SDI’s model is that as soon as they purchase a company it becomes valued at a higher multiple as part of the whole. So value created overnight - not sure about that.

In terms of tipsters, I think each company attracts it’s own type of shareholder, through it’s actions. SDI’s shareholder register is probably less vulnerable to tipsters than, for example, an Oil and Gas exploration company’s shareholder register.

Was it Mark Simpson? In which case I am a little surprised because he usually makes sense. Maybe this company is just not his cup of tea, which is fair enough.

Regards,

Ben

[Ben123]

Hi Diogenes,

What Mr Simpson wrote was;

SDI (SDI.L) - Interim Results

The headlines read well:

Revenue increased by 75% to £24.7m (FY21 H1: £14.1m), including 42% organic growth

And a gold star for SDI for breaking out the growth into the different streams:

o Continued strong contribution from Atik Cameras due to one-time COVID-19-related contracts, expected to complete by January 2022

o £4.6m sales contribution from Monmouth Scientific and Uniform Engineering, acquired in FY21 H2

o Organic sales growth in all other businesses averaged 22%

They seem to be lacking some operational gearing though:

Adjusted diluted EPS* increased 59% to 3.92p (FY21 H1: 2.47p)

Which is down to slightly lower gross margin, higher taxes but primarily much higher operating costs. Operating Cash Flow is also weak due to prior customer down-payments reversing:

Cash generated from operations decreased by 6% to £4.4m (FY21 H1: £4.7m)

Overall, they say:

We look forward to delivering a full year performance in line with market expectations

And helpfully give what these expectations are:

Analysts from our Broker finnCap Limited and from Progressive Equity Research regularly provide research on the Company, and the Group considers the average of their forecasts to represent market expectations for FY 2022 being Revenue of £45.05m and Adjusted2 Profit Before Tax of £9.2m

This is not particularly great, however. Since this means that H2 sales will be 18% lower than H1, with H2 PBT dropping by a whopping 39%. That isn’t good and is presumably because the Atik Cameras sales for COVID PCR testing were one-off and are now mean reverting. finnCap reflect this mean reversion in their 2023 forecasts:

So £41m revenue and 5.3p adjusted EPS, which is below 2021 EPS as well as 2022E.

Still, this is a quality company, with an underlying organic revenue growth excluding Atik of 22% and the potential for further bolt-on acquisitions then it isn’t hard to argue that a P/E of around 25x wouldn’t be out of place.

However, a 25x P/E represents a share price of around 130p/share, some 30% below where the current price is. One to keep on the watchlist, though. The market tends to hate these mean reversion stories. Best of the Best, for example, dropped 80% when it became clear that their strong short-term performance was largely a one-off. As has happened multiple times in the past, a 50% drop in share price could make SDI look good value again.

It’s a free e-mail so I don’t think he will particulatrly mind me copying it.

Mr Simpson’s criticism seems to be:

1. SDI is not operationally geared, which I agree. However I think operational gearing is two-edged as already discussed on the other thread. I have seen a few companies reporting recently who have increased costs as much as they have increased revenue. I think the company said there is a cost catch-up from 2020, which is covid related?
2. Mean-reversion. I think he is referring to the fact that BOTB and other covid beneficiaries have been hammered when their markets have returned to more normal trading, which is true. SDI was a covid beneficiary in that alot of cameras were sold for covid reasons (to China, it seems), which could cause a reduction in demand in the future.
3. H2 PBT being lower than H1 PBT. As Mr Simpson says, this is relating to covid. I don’t know what the company could do about this. It doesn’t worry me - the company seems to have done very well increasing profit from the below chart, over a longer time-frame:

4. A reduction in cash generated from operations H1 2021 vs H1 2020. In the rns, the company explained:

Prior year included a substantial build-up of customer down payments related to the one-time COVID-19-related contracts

I think he may have missed this and I am very happy with the development of operating cash within SDI:

5. It’s possible to wait for a price dip. Indeed that has been the case in the past:

But having said that, the major dips were before SDI had built up such compelling free cash flow (ref below chart).

For me, Mr Simpson’s comments don’t factor in;

1. The US opportunity for Monmouth Scientific.
2. That ebit etc would increase should further acquisitions occur before the end of 2022. This is quite likely, but it’s prudent not to include possible future acquisition revenue within current forecasts.
3. SDI say they are in the position to acquire companies from free cash flow, now, rather than going cap in hand to the city which is an advantage.
4. The CEO has a finance background. I think this makes him good at acquiring companies and allocating capital.

I find these charts quite compelling:

Conclusion
I agree with a lot of what Mr Simpson says -

• the share price may drop 40%, temporarily, when covid is no longer an issue (a la Tristel).
• valuation has increased substantially over the near past

If one were a trader, maybe this share should be sold?

Personally I’m going to continue to hold because if I sell one company based on valuation I would end up spending all of my time looking at other portfolio company valuations relative to their peers, rather than company performances. I think for H1 2021, the company performance for SDI was good.

You may be interested that there is a the Meet The Company presentation at today (4pm)? It will probably be on their website next week.

Regards,

Ben

[Diogenes]

Thanks for the deeper analysis. My take is that they have a portfolio of companies with different characteristics - so the group is bigger than the sum of the parts. Different companies respond to different parts of the business cycle in different ways. As long as cash-flow grows and ROCE/CROCI stay within bounds, then I don’t see the problem. But recent growth has been so rapid so it would not surprise me if it flatlines for a little while. I see no reason to bail out at the moment