Business going for a song (and a one-legged dance)

Imagine that you are the owner of a manufacturing business.

You manufacture leading edge scanning equipment which scans and analyses materials in realtime.  Your customers are operators of cement factories, coal mines, coal fired electricity stations and iron ore producers, and you are proud of your product because it saves costs for your customers. Moreover, it is good for the environment as your machines reduce wastage, reduces electricity usage and increases plant efficiency.

Your business has a history going back to 1981, with a founder hailing from the esteemed CSIRO.  You employ a group of dedicated engineers who has created ingenious products which have been successfully installed in over 1000 locations around the world. Your patents and intellectual property portfolio is valued at over $1m. Your business has weathered the turbulent economic climate for over 3 decades, and most recently has emerged from the GFC unscathed.  Your bank is flushed with cash of over $5.2m, and you  own your own factory valued at $4.43m, with a $2m mortgage on it. Other than that, you owe the banks nothing.

Your business has had its up and downs, but nevertheless the business has generated profits for the last 7 years, even through the trough of the GFC. You have build up net value from under $5m all the way to over $10m in 6 years, despite generously returning over $1.7m in capital to all shareholders last year. Business is good, with a backlog of orders. on the books. You will probably make about $1.5m to $2m this coming year.

One day, some hotshot investment banker walks into your factory. He takes a look around, and says that he will offer to buy your business, your factory, your IP, your management team, on a walk-in walk out basis for $8m. He figured that you have $5.2m in the bank, $4.4m worth of real estate property and a mortgage debt of $2m, which comes to roughly $7.6m, and he says you can keep the change.

Would you agree to sell? Chances are you would tell the banker to go to hell. The offer is insulting. Even if you make only $1.5 m per year after tax, you would probably be asking for $7m at least for the business on top of the cash and property values. A realistic offer to start talking would have to be in the vicinity of $15m.

For some curious reasons, even with exactly the same situation, things work slightly differently in the sharemarket.

On 11 March 2013, Mr Market is kindly offering me a slice of Scantech Limited (SCD) for 45 cents. With 17.6m shares on issue, plus about 1.7m worth of options exercisable at prices of 70 cents and above, the undiluted market capitalisation of SCD at 45 cents is $7.9m.

This is the 90 seconds pitch to buy SCD:

“As at Dec 2012, SCD has $5.2m of cash in the bank. It owns a factory valued at $4.4m, and this factory has a mortgage securing $2m. Cash and property less debt totals $7.6m. At 45 cents, SCD has a current market cap of $8m. At this price, the business is valued by the market at just $400k. The business has been profitable for the last 8 years, and generated cash of $50k and NPAT of $260k last half year. The company manufactures and supplies equipment which analyses compositions of materials in realtime on conveyor belts. The equipment is used by companies in bulk commodities such as cement, coal and minerals. The order book is increasing and stood at $9m as at Dec 2012, and importantly service revenues are starting to catch up with equipment sales. Management owns a substantial amount, and navigated the GFC without making at losses or raising any capital. In fact, they did so well that they returned $1.7m to shareholders as a capital return in 2012. Management has given guidance for a similar result in 2013 as 2012, which is about $1.7m of NPAT.”

This is the 90 second pitch against buying SCD:

“The company owns the factory and therefore does not pay rent. Let’s assume the company sold the land and leased it back at market rates. As industrial property is valued at yield, taking a conservative 8% yield on $4.4m yields a yearly rental expense of $352,000. We credit the finance costs of $130,000 per annum (since the $2m mortgage is no longer required) to yield a net expense of $222,000 impacting the bottom line. This virtually wipes out half of the half yearly profit to $150,000, and puts the company into cashflow negative for the half.  In this scenario, the company will have $7.5m of cash, and a business barely breaking even.  We should assume mining capex is decreasing going forward, and thus 2012 and 2013 will probably be peak revenue for SCD. $8m is probably a correct fair value, being $7.5m of cash with a nominal amount of $500k for the business which has historically erratic margins, net profits and cashflow.”

The critical investment issue with SCD is just simply, is the business worth more than $400,000 and if so, how much is the business worth? The problem with the negative case is that the first half is traditionally the weak half. SCD sold 11 machines, but is contracted to deliver 17 machines the next half. So we can be reasonably confident that figures for the full year will be respectable, probably above $1m in NPAT.  If we average out NPAT over the last 7 years, we get average NPAT per year of $850k per annum. A conservative 6x multiple for this equates to $5m. These are conservative, and we can easily mount an argument for the business to be valued at $8m. If this is so, addition of cash and property yields intrinsic values of $15m to $16m, double the current market cap, thus achieving a 50% margin of safety.

The downside to SCD is adequately covered by real cash and hard assets. The cashflow of SCD is also covered by an increasing stream of service fees. Service fees have increased steadily from $1.9m in 2006 to $4.5m in 2012, and the only year it has dropped is 2011 by a mere 10%. As the installed base of equipment gets larger, service fees will form an important buffer to earnings going forward. Another investor has pointed out that any decline in mining capex will not have a major impact on operating mines which will concentrate on production efficiencies, thus increasing opportunities for SCD.

Enjoy and prosper.

Disclosure: The author owns shares in SCD.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.