external headwinds mask a great growth story

A confluence of extreme events have conspired against SDI over the past 12 months, and yet its financial performance has proven remarkably resilient.

For context, from 2004, which as far back as I have gone back in studying SDI results, the company has grown revenues in A$ terms from to $54.6m today, from $42.5m in 2004. That equates to a CAGR of 3.6%pa, without any recourse whatsoever to shareholders for funding.

While that might seem reasonable, it masks the true story: with around three-quarters of SDI’s sales occurring offshore, and given the strengthening A$ relative in recent years, when measured in US$ terms, the CAGR in SDI’s top line is more like 7.6%pa.

Because SDI has traditionally had most of its manufacturing capacity located in Australia, this strengthening A$ would also have had an adverse effect on the group’s gross profit margins.

Not just that, but one of the key inputs into SDI’s alloy products, namely silver, has seen its price rise almost exponentially, from sub-$5/oz in the early 2000s, to over $40/oz this time last year.

One would expect that, under such acute shocks, GP margins would get absolutely crunched. Yet they haven’t; while they may be off their historical peaks, they remain very high in the high 50%’s:

SDI Gross Profit Margins:
DH03: 72.9%
JH04: 70.0%
DH04: 57.6%
JH05: 65.8%
DH05: 66.7%
JH06: 68.7%
DH06: 66.6%
JH07: 66.7%
DH07: 62.3%
JH08: 60.0%
DH08: 62.7%
JH09: 61.5%
DH09: 67.5%
JH10: 64.1%
DH10: 61.6%
JH11: 57.9%
DH11: 57.6%
JH12: 57.2%

This clearly points to pricing power, in my mind, albeit with a lagged effect.

Another feature of SDI’s financial track record is the apparent close cost control.

Admin costs have remained stable for the past 4 years, and have escalated at just 1.8% pa on average over the past decade.

The Cost of Doing Business-to-Sales ratio history speaks volumes for the cost culture of the company, which is most often the case with multi-generational, family-run businesses where the founders and their offspring retain significant stakes in the business:

SDI’s Cost of Doing Business-to-Sales Ratio:
DH03: 54.1%
JH04: 37.9%
DH04: 51.8%
JH05: 51.2%
DH05: 52.6%
JH06: 50.3%
DH06: 52.9%
JH07: 47.5%
DH07: 51.1%
JH08: 49.3%
DH08: 54.4%
JH09: 53.2%
DH09: 56.7%
JH10: 51.5%
DH10: 54.1%
JH11: 50.1%
DH11: 50.6%
JH12: 45.3%

[As an aside, I flew down from Sydney to Melbourne last year to attended SDI’s AGM...a very austere occasion with no frills.

They hold it at their factory/head quarters situated out in the industrial fringes of Melbourne.

No ritzy CBD hotel venue, nor an swank conference centre; just in some warehouse-type premises.

No glamorous blue ribbon HQ adorned with expensive artwork, no plush, thick pile carpeting, no expensive boardroom furniture, no expensive luxury vehicles in the car park...just a very modest address in the midst of a bunch of warehouses, well off the beaten track.

And that’s the way investors should like it.]

Besides the excellent cost control, another feature of this latest financial result is the management of working capital, particularly inventory.

Inventory-to-Sales, at 14.6% for the past 6 months, is at an all-time low. As the company has gained scale over the years, Inventory-to-Sales has fallen consistently from over 30% in the early 2000s, to today’s level.

The result in FY12 was strong operating cash flow of $6.5m and FCF of $3.2m which is material in the context of a company with market cap of just $18m (i.e., trading at ~5.5x FCF at a time when the company has been in a perfect storm in terms of the external drivers of the business, namely the silver price and the A$:US$ exchange rate).

A consequequence of the strong cash performance is that net debt has fallen to $8m, down from $11.2m six months ago, and $13.8m twelve months ago.

I have probably wrote more on SDI than 99.99% of HotCopper readers care to know about, but I wanted to hold it up as an example of how a business can forge ahead despite some of the worst possible macro headwinds.

Going forward, for SDI to grow, the A$ and the silver prices don’t even need to fall; even if they remain elevated at current lofty levels, SDI’s investment in R&D, growth in sales volumes, pricing ability, unrelenting cost control, balance sheet strength (NIBD<1.2x EBITDA), and granular nature of the business, will easily see Sales growth >7% and EBITDA growth of 20% in FY13 (bearing in mind that JH12 vs JH11 EBITDA growth was 49% despite the A$ strength).

Valuation-wise, that would put the stock on a P/E multiple of less than 7 x, an EV/EBITDA multiple of 3.6x, and a FCF yield of 15% on the Market Cap and 11% on EV.

These are all very undemanding metrics, in my opinion, for a company with SDI’s growth potential, once the extraneous headwinds that have buffeted the company in recent years, stabilise (remember: they don’t need to “normalise”; they just need to stabilise).

I know it’s a highly illiquid stock and trades almost by appointment only, but as a long-term holder I like that, because the volatility from time to time provides excellent buying opportunities (for example the past 6 months when some bored and/or anxious holders let go of the stock at 10c, equivalent to a 25% FCF yield, i.e., a 4-year payback...crazy, I know, but it happens).

I look forward to the next two years with SDI.

Prudential Investing

Cam