Asymmetric Return on Offer...

Any investment case discussion about SP3 should be prefaced with acknowledgment that it is not a business of great quality:  the market place for SP3's service offering is competitive, product obsolescence rates are high and there is sales execution risk.  And SP3 management, being very new almost across the board, does not have a shareholder value creation track record from to draw precedent.

In terms of business model appeal, on a scale of 1 to 10, I'd score it a 5.5 to 6.o out of 10 business.  

But the key point to note about the business is that it's current market value belies some of the reasonably decent traction that was occurring since the company's 2017 IPO.

Until Covid impacted the business (and it's not a lame excuse - the company's business was definitely impacted by customer pause in the past 3 quarters), Revenue and Gross Profit were trending in the right direction:



To be balanced, SQ Revenue was also softer than pcp, reflecting lingering Covid impact. But it is worth noting that the rental fleet increased by 20% over the course of the September quarter, from 240 at the start of the quarter, to 290 units at the end.


This rental revenue component is an important consideration when it comes to understanding the drivers of SP3's P&L, specifically at the Gross Profit Margin level.  

As can be seen, GP Margins have ratcheted upwards in every financial period since listing:


(Not quite sure what happened in JH17 and DH17 - my guess is that there might have been a bit of a timing discrepancy in terms of CoGS recognition. But it is not overly meaningful because that was at pre-IPO stage, so there may have also have been some re-statements which I haven't bothered to properly decipher.)

Suffice to say that's an attractive GP Margin trend, which reflects the changing sales mix of the business, as it moves increasingly towards a rental model (along with the associated software services), as opposed to a unit sale model.

Of course, there's no such thing as a free lunch, and the higher-margin rental model come at a cost of increased capital intensity.  

Therefore, no one should expect SP3 to be a generator of free cash flow for the next twelve, and possibly even eighteen, months.  Because there is going to need to be some meaningful investment ahead of the curve.

So it would come as no surprise to me if the company ended up consuming $2.0m over the course of FY2021 and possibly be not quite at FCF break-even in the following year, depending on how hard they want to drive the sales and marketing effort.

And by the sound of it, they want to drive it hard, so I don't think they will be sparing the horses.

This means that forecasting SP3's financials is very difficult (low investment in costs means low revenue growth, and vice versa, as well as all the combinations and permutations in-between).

My best guess - and it represents but one of many possible scenarios - looks something like this:





[Assumptions:
- Revenue CAGR between FY20 and FY23 = 38%pa  
- Gross Profit Margins = 63% (cf.  FY20's 64%..... DH19 = 62.7%; JH20 =65.6%)
- 20% Increase in CoDB (R&D, G&A, Marketing, Occupancy and Employee Expenses) between FY20 and FY23
- Working Cap-to-Sales rising to 10% (JH20 = 8.4%)]


As can be seen, on that basis the company only becomes profitable in FY2023 and the Net Cash balance troughs at $0.5m in FY2022.

Clearly, once the business is at scale (Revenue in the low teens of millions of dollars), its high GP Margin characteristics and capital-light business model mean that it will be a significant free cash flow generator.

Trouble is, we need to get through the upcoming 12-18 month heavy investment period first.   

And, as can be seen, it could be tight, capital-wise; which means that a further capital raising cannot be ruled out at some point.

So the way one should view an investment in SP3 is that, should they execute well the company will be worth several multiples more than its current market value (remember that the CEO's performance rights kick in at a share price of 20c, so...)

And if the execution is poor, then I think the end game is that the "For Sale" sign gets hung out and some other entity buys the company for its IP and whatever levels of Gross Profit is being generating at the time... maybe $3.5m or $4m.

Because a new corporate owner would be able to eliminate the bulk of the current $5m of fixed cost overheads and end up with, maybe a $2m, or even $3m, EBIT business.  

Such a scenario would easily justify a lot more than a mere $5m (the current market value) sale consideration.

So I think it is a situation of:  "Heads - I Win A Lot;  Tails - I Don't Lose Much".
(Actually, I think the second part is "Tails - I Win a Little Bit Anyway")

The only problem is that before the end game is reached - whether that end game is I recoup my capital in a scorched earth takeover scenario, or whether I make out like bandit because the company's Sales treble - there is a lot of water that needs to flow under the bridge.

In other words, the exercise date on the "free option" that is an investment in SP3 is probably more than 2 years way
(meaning the option is not totally free given that there is a lot time value for which one effectively has to pay).

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