SDI Group: The Good Storm That Introduced An Attention-grabbing Funding Alternative

Funding Thesis

SDI Group (OTCPK:SDIIF) is a fallen angel inside the small caps of the UK. The corporate had achieved spectacular returns within the final decade; nonetheless, the final worry available in the market, excessive inflation within the UK, the exit of investments in small caps, an impairment, and the termination of a contract that had massive revenue margins created the right storm.

On this article, we’ll discover these important headwinds that specify the 50% drop from all-time highs and analyze the best way to incorporate all of this into the valuation to find out if, on the present value, SDI will be thought of a doable good funding. Anticipating, I certainly contemplate it to be.

Enterprise Overview

SDI Group is devoted to designing and producing measurement and management devices for very diverse and fairly area of interest sectors similar to life sciences, healthcare, astronomy, aerospace and artwork conservation. Regardless of its measurement, the corporate has a observe document of accurately executing its development technique over the past decade.

About half of gross sales are generated inside the UK, SDI’s house nation. Once more, regardless of being a small firm, its income is diversified geographically.

The merchandise are segmented into the classes of Digital Imaging and Sensors and Management.

Digital Imaging

This division makes up roughly 30% of the corporate’s complete gross sales.

Inside this division, there are numerous product traces, together with Atik Cameras, that are identified for his or her excessive sensitivity and are utilized in functions similar to capturing clear photographs of deep-sky astronomy.

One other important model underneath this division is Syngene, which produces tools designed for scientists to seize photographs for protein and DNA evaluation. These examples present perception into the kind of merchandise manufactured inside Synoptics Group’s Digital Imaging section.

Sensors y Controls

This section accounted for 70% of the corporate’s gross sales in FY2023.

Inside this section, the corporate operates a number of manufacturers. As an example, Astles makes a speciality of supplying dosing and management techniques for chemical merchandise to beverage can producers and engineering element and engine producers. Monmouth Scientific is concentrated on offering filtration fume cabinets and installations designed to keep up clear air environments. Sentek specializes within the manufacturing and sale of custom-made electrochemical sensors primarily utilized in water-based functions.

These sensors discover functions in laboratory evaluation in addition to inside the meals, beverage, and private care manufacturing sectors.

Acquisitions

To capitalize on the extremely fragmented and specialised nature of the markets by which SDI operates, the corporate has been implementing an acquisition technique for a number of years. A good portion of the corporate’s development will be attributed to those acquisitions, as natural development usually hovers round 5%. Nonetheless, there have been exceptions in FY2021 and FY2022 (equivalent to the actual years 2020 and 2021) when substantial orders have been positioned for Atik cameras because of their functions in COVID-19 identification.

Whereas these orders quickly boosted natural development and gross sales, they’re anticipated to be accomplished within the present FY2024, resulting in a normalization in development and margins. We are going to delve into this matter additional.

SDI adheres to a well-defined acquisition technique that it has diligently adopted in recent times. The technique contains the next steps:

Hunt down worthwhile firms that generate Free Money Circulation. Consider the monetary historical past of the goal firm to make sure its stability. Give attention to firms which might be leaders inside their particular area of interest. Search for firms with a reliable and efficient administration staff in place. Pay a purchase order value equal to 4 to six instances EBIT (Earnings Earlier than Curiosity and Taxes).

As soon as SDI identifies an appropriate acquisition goal and the transaction is accomplished, the corporate integrates the acquired merchandise into its portfolio. It additionally implements strong monetary controls and permits the acquired firm’s administration staff to proceed operating the enterprise autonomously. By this method, SDI goals to boost the acquired firms’ gross sales, margins, and total development by capitalizing on synergies.

Since 2014, SDI has efficiently executed 17 acquisitions following this methodology. Sometimes, they fund acquisitions utilizing their current internet money or by taking up financial institution debt after which they repay this debt shortly after finishing the acquisition. This has been the recurring course of for the previous 8 years.

As beforehand talked about, the market is very fragmented, with over 2,000 potential acquisition targets in the UK, in line with the administration. Many of those firms have been based by people who at the moment are of their 40s to 50s and are searching for retirement and not using a clear succession plan for his or her companies. Consequently, promoting the corporate turns into probably the most viable choice, leading to a constant pipeline of potential sellers every year.

FY2023 Outcomes

On September 3, SDI reported its FY2023 outcomes, which initially appeared fairly poor:

Gross sales £67.6M (+36% YoY). EBITDA £11.8M (0% YoY) which represented an EBITDA margin of 17.5%. EPS of £0.04 (-49% YoY) and a revenue margin of 5.8%.

However beneath these outcomes lies an impairment that muddied the precise figures, due to this fact, it is essential to normalize SDI’s outcomes to realize a clearer understanding of the corporate’s efficiency.

To be exact, the impairment amounted to £3.5 million. By including this quantity again to the reported income, we arrive on the following figures:

Gross sales £67.6M (+36% YoY). EBITDA £15.3M (+30% YoY) which represented an EBITDA margin of twenty-two.7%. EPS of £0.07 (0% YoY) and a revenue margin of 11%.

The outcomes should not as dire as they initially seem, and I’d even enterprise to say they’re fairly constructive. The problem the corporate faces is that, for this fiscal 12 months, they’ll expertise a lack of roughly £8 million in income from high-margin Atik digicam contracts. Subsequently, it is essential to take this issue into consideration within the valuation, as we’ll discover shortly.

It is important to focus on that an impairment will not be a positive prevalence, because it signifies that the board might have overpaid for the acquisition of Monmouth. Nonetheless, it is reassuring to notice that such impairments don’t seem like a recurring problem for the board, which is a constructive side given their historical past of 17 acquisitions over the previous decade.

Key Ratios

The corporate has achieved exceptional development, with an annual improve of 27% between 2017 and 2023. Moreover, throughout this identical interval, EBITDA has grown by 35%, and Free Money Circulation has surged by 55%, indicating enhancing margins.

A better look reveals that the expansion within the EBITDA margin has been gradual. Nonetheless, within the case of Free Money Circulation, there was explosive development in 2021 and 2022, adopted by a normalization in 2023. This development aligns with the contracts for the Atik cameras, which have been doubtless executed with very favorable margins.

The corporate’s potential to attain a 15% common Return on Capital Employed and an analogous Return on Free Money Circulation invested is a key metric for assessing the effectivity of SDI Group’s acquisitions, provided that acquisitions characterize the first use of capital.

From 2018 to 2022 (FY2019 to FY2023), the first sources of financing have been money from operations and debt, in equal proportions, as beforehand talked about. Capital was predominantly allotted to acquisitions and repaying the acquired debt.

This method is obvious: use debt for acquisitions and subsequently pay that debt with generated money. Nonetheless, with latest will increase in rates of interest, it will likely be important to observe the corporate’s monetary place. Extremely leveraged conditions might require a pause in acquisitions sooner or later.

By way of solvency, the corporate possesses practically 2 instances extra property than complete liabilities, indicating that it has the capability to promote its property to cowl all liabilities twice over in case of debt points.

Concerning liquidity, SDI maintains 1.7 instances extra property than liabilities, signifying that it’s in a powerful monetary place to satisfy its short-term obligations and money owed.

The Internet Debt/EBITDA ratio, nonetheless, is exhibiting an upward development 12 months after 12 months, though it stays at a manageable stage of 1x EBITDA. Monitoring this ratio to make sure it does not method 2x ranges within the coming years will probably be essential.

It is essential to notice that these information are adjusted for the talked about impairment, permitting us to gauge the underlying enterprise efficiency with out the noise generated by this accounting adjustment, which does not entail a money outflow.

Valuation

For the valuation, it is essential to think about a normalized surroundings of development and margins. Administration anticipates making 2 to three acquisitions throughout FY2024 and expects a lack of roughly £8M because of the Atik digicam contracts. The corporate usually experiences natural development starting from 5% to 10% and for this 12 months the target stays the identical.

(Supply: Ultimate Outcomes Investor Presentation)

Moreover, with the lack of contracts that includes exceptionally excessive margins, it is prudent to scale back the EBIT margin to the historic ranges of round 15% that have been prevalent previous to buying these contracts. It will present a extra real looking foundation for the valuation.

In FY2023, the corporate made 2 acquisitions contributing £17.5 million in income (roughly £8.75 million per acquisition). In the event that they make one other 2 acquisitions within the present 12 months, I may estimate £15 to twenty million in gross sales. Nonetheless, to be conservative, let’s assume they solely make an £8 million acquisition, and natural development stays at 0% because of recession considerations. Thus, FY2024 internet development could be round 0%.

Following this difficult 12 months, it is affordable to count on the corporate to return to its typical development trajectory, however we’ll contemplate a extra conservative 15% development fee as a substitute of the earlier 27%. For exit multiples, we’ll use 12x EV/EBITDA and 15x EV/FCF, per historic ranges earlier than 2020.

With this conservative valuation, it is doable to estimate a compound annual return of 15% from present costs if bought from the London Inventory Change since valuation might differ barely if bought OTC.

Dangers

Curiosity Charge Fluctuations: Adjustments in rates of interest can considerably influence the price of debt and due to this fact will have an effect on the corporate’s potential to make acquisitions, except SDI decides to sacrifice monetary energy with a view to proceed rising inorganically, which I’d contemplate very dangerous.

Integration Challenges: Efficiently integrating acquired companies will be complicated. Cultural variations, know-how integration, and administration alignment can pose important challenges and whereas the corporate has a fantastic observe document of doing this correctly, it’s nonetheless a danger to think about.

Market and Know-how Threat: The measurement and management devices trade could also be topic to speedy technological developments. If the acquired enterprise operates on outdated know-how, it might turn into out of date rapidly and development and synergies could be worse than anticipated.

Ultimate Ideas

The corporate’s present situation justifies the latest drop in its inventory value, however I’ve chosen to take a conservative method in valuing it. Regardless of its challenges, the corporate stays well-managed with a powerful observe document, wholesome revenue margins, and a excessive return on capital employed.

Debt ranges would require shut monitoring, however I consider the corporate has the potential to attain 10% annual development within the coming years with out requiring important debt that places SDI in danger. Subsequently, I am giving it a “purchase” ranking whereas protecting a watchful eye on its monetary scenario.

Editor’s Word: This text discusses a number of securities that don’t commerce on a significant U.S. change. Please pay attention to the dangers related to these shares.