SDI Group PLC - Is it worth it?
Short-Term looks bad, but what about the Long-Term View?
DISCLAIMER: This article is not a recommendation to buy or sell any financial instrument. Please do your own research. My analysis could be totally wrong and the stocks could have negative returns.
DISCLOSURE: I own shares of SDI Group PLC
SDI Group PLC is a serial acquirer of niche scientific businesses. They own a portfolio of small businesses that mostly manufacture and sell physical science-related instruments. It is important to note that only a small portion of their revenue is recurring, so the businesses are not of top quality.
The mathematical attractiveness of their Buy and Build strategy is the following:
They want to Buy companies at a 4-5x EBIT multiple, which translates to a 5.3-6.7 free cash flow multiple after the 25% tax rate. That alone should give them a 15-19% free cash flow return on invested capital.
They want to Build the companies they bought, targeting an organic growth rate of 5-10%.
In theory, if they execute correctly, they could grow the intrinsic value of the group at a 20-29% CAGR if we count both acquisitions and organic growth. But of course, that is just the mathematical theory, reality is quite more complex. Sometimes they will overpay for businesses, some companies will under-perform, they will add risk and interest payments through debt, working capital will be lumpy and finally, they will add overhead expenses. All these problems will reduce returns.
The short-term view
For quite some time I thought that SDI Group PLC was overvalued due to covid-inflated earnings, and it has been proven that I was right. I even said it on this blog post when SDI was trading at over 150p and several times on my X account.
The following post is a summary of the latest events:
Due to covid, SDI got a very large contract to provide cameras to a Chinese customer. The contract lasted three years (FY21-FY23) and was recognized under the Digital Imaging segment of the company. As you can see in the table below, Digital Imaging had inflated earnings during the last three years and the earnings of the segment have crashed in H1 2024 to even below FY2020 levels (pre-covid, fiscal years end in April). According to management, earnings of Digital Imaging are depressed due to the transitional destocking of a major customer that did not make purchases in H1 2024, reducing earnings by £1m. 3 of the 15 business units are currently under-performing, the other two reducing profits by extra £0.2m each.
The inflated earnings of Digital Imaging plus the normal cashflow from other businesses and some debt have been used to buy new companies under the Sensors and Control segment, which has experienced a lot of growth, and that is great. “Other” expenses have grown a lot as well, and that is not good. See the table below:
I would argue strongly that management mislead shareholders for the last three years by not explaining correctly how much of their earnings came from the one-off covid contracts (they did disclose revenues though). When you add exceptional orders to a normal business, without the need to add additional fixed costs, all the gross profit flows into operating income. They also made ROIC calculations using inflated earnings that were totally misleading to investors. The market ended up pricing SDI Group at high multiples of inflated earnings and experiencing draw-down of 60% once the normalized earnings were revealed.
The 29th of September 2023 management gave guidance of £9.8m profit before tax when there was only one month left for H1 to end. The guidance was revised down 20% to £7.9m - £8.4m once H1 results were presented, two months later. Management explained that this was due to a big order getting postponed because of the destocking of a major customer of Atik Cameras plus the slight under-performance of two other companies, and that they expect earnings to grow organically and recover during FY25. I personally initiated a position at 94p and bought some more at 108p before guidance was revised and was totally shocked that numbers could change so much in just one month. Management explained that it was a surprise to them aswell, but I still think that their guidance was too aggressive. I’d rather them not giving guidance at all, if there was no guidance, I probably would not have bought in the first place until I saw the H1 results come out… I stepped in the guidance trap.
The doubts on management might be enough of a reason for many to not buy shares, and I would totally understand. Management does not own many shares and they raised their salaries significantly during the last years of inflated earnings.
In the short-term, I think it would not be crazy if the market assigns a low multiple to depressed earnings due to low trust in the management team. After all, who says they can’t revise guidance down again like they just did? Six months are left before we see the H2 2024 results (although we should see a trading update in three months).
If they finally end up achieving the low end of guidance, that should leave SDI with around 5.9m FCF (excluding working capital, including SBC, according to my own guesstimates), so the company is currently valued at 14.5x FY2024E FCF at 82p.
If the market assigns a low multiple of 10-13x FCF, the stock price could fall to 57-74p in the short term. If this happens, it could be a nice opportunity for Long-Term investors. Current sentiment is and should be negative, but I will now argue why I still think the Long-Term looks bright:
The Long-Term view
Management has made a ton of mistakes communicating the results and the inflated earnings to shareholders for the past three years, additionally, it is a red flag that they do not own enough shares. Operationally, however, there has not been as many mistakes. They used the one off Covid cash flows to buy companies at attractive multiples (if you exclude the real estate properties they had to buy with the companies). They did admit that the Monmouth acquisition was a mistake and impaired it’s goodwill.
Adjusted Profit Before Tax and Free Cash Flow will more than double since 2019 if they hit the low end of the guidance. It is probable that management is right in assessing that FY2024 earnings will be depressed, and we could see a recovery of the Digital Imaging segment in FY2025, plus organic growth, plus new acquisitions.
Debt to expected Free Cash Flow is at 2.2x, which is below my 3x limit for serial acquirers which I am comfortable with. I still think they can do some acquisitions this or next year with current debt levels. I think it is possible that they can have nice organic growth in FY2025 due to depressed earnings in FY2024. They even hired a new COO to help with organic growth.
If management hits guidance for this year and earnings recover in FY2025 plus they keep executing as they have done in the past, I do not find any reasons to why the stock should not re-rate to a 15-25x multiple of a much higher free cash flow in the future. But keep in mind that they changed guidance and it could happen again, so the short term remains cloudy. I would argue that Long-Term investors will do well even at the current price if management can hit guidance.
My conclusions
I have not sold a single share of SDI Group PLC. I have not added many shares either for now (just some). I am not happy with management’s latest mistakes but I think that they will do better in the future as they did pre-covid. Covid really was a crazy period for science-related businesses and I understand that some mistakes could have been made.
In the short-term, I would add more to my position in the 57-74p range, if it does not fall there, I will just hold until there is more clarity on the earnings stability or until I see a good acquisition that increases intrinsic value. If they report good earnings in six months and they do some good acquisitions, I will add at a higher price, I have no problem with that, I just need to be cautious in the short-term in case they miss guidance again.
Thinking longer-term, I think that management will keep executing at a good level going forward, as they have done in the past. Since FY2016, they have grown revenues almost by 8x, operating income by over 14x (with shares outstanding up 60%).
The Buy and Build strategy has been proven successful, and, although there have been some mistakes in the past years, I do think that they will keep executing well and Long-Term shareholders will be happy. The Short-Term looks cloudy due to management’s mistakes, mostly in shareholder communication, but also in some acquisitions, but if the Long-Term looks anything remotely to what they have done in the past the stock should do well.
If we look at the pre-covid era, results were crazy good. I don’t think they will be able to repeat these results, but I think they have a proven track record:
If we look at a longer time frame, it’s still excellent. So I guess shareholders will have to be patient:
Updates
22 January 2024: Today the CEO Mike Creedon left the company. Additionally, the company did not take the opportunity to reaffirm their guidance in the press release, so maybe they are going to miss it. There is no explanation to why Mike left. The recently recruited COO will be the new CEO. If they hit low range of guidance it is trading at 12.8x FCF. I would not be surprised if given current uncertainty we see it trading at 8-10x FCF. If they miss the low range of guidance it could fall a lot. They should report final results around May as they did last year but it would be nice to hear something from them earlier. Mike’s salary was 480k, around 8% of FCF. Although he has been good for long-term shareholders, he has lied to recent shareholders and I will not miss him. Current valuation looks low and it shouldn’t take much to get the company back on track. If the new management can keep doing acquisitions at 4-6x EBIT and achieving 5% organic growth, returns will be great from here, I am giving them some time. I have not sold, might buy more if results turn out fine or I see new acquisitions at good prices. I will not miss Mike.
25 January 2024: People are selling SDI indiscriminately, it now trades at 10.5x FCF of the low range of guidance. I have taken this opportunity to add strongly to my position. The same guys who bought the covid-inflated earnings of the digital imaging segment are now selling at any price just because Mike Creedon (who lied to them and had some bad acquisitions lately such as Monmouth) left the company. The valuation is starting to be ridiculously low. The company’s strategy has not changed and if they stick to their acquisition parameters and the Sensors and Control segment keeps growing they should do fine.
13 April 2024: Added a graphical explanation on the segments (click here).
20 May 2024: SDI reports results in line with what I expected (click here),
30 July 2024: Notes on the FY24 call. Acquisitions comming soon (click here)
13 August 2024: Updated segmental report graph with FY24 numbers
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Kind regards,
Oscar.
excellent write-up! corona hangover should end soon and we can see the true profit levels .
Great write up. Thanks Oscar. I am also a shareholder and I have not sold any share yet. I think communication in the last years could be better and they should have shown adjusted numbers during the COVID contract duration to show a more real picture of the situation. I am also not happy with the latest salary increase, management is getting expensive and even more expensive if they do not create shareholder value as before. I am also with you that the prospect for SDI in the long run are unchanged: strong organic growth, strong pipeline for M&A and proved track record. Let´s how the SDI story evolves ...