Ann: Annual General Meeting - Managing Director's Presentation, page-8

"Could you please explain what you mean by "gnarly" business? I think I understand the term in general colloquial usage but also think I might benefit from an elucidation of what aspects you see as difficult or detrimental."

@arsenic, (by name only, I trust, and not by nature)

The best way I think I can explain it is by starting with what the opposite of a gnarly business - i.e., a beautiful or world-class business - looks like.

The best-of-breed companies demonstrate the following traits:

- Non-cyclical and recurring revenue streams, growing organically with the support of structural tailwinds
- Granular customer base (i.e., no large customer concentrations)
- No dependency on critical business inputs
- Non-commoditised service offering with limited competition resulting in pricing power
- Easily scale-able, requiring limited capital to grow
- Capital-light with high asset turnover
- High gross and operating margins
- Conservatively struck financial accounts, containing prudential padding.

(Note that no company possesses all of these traits; even the best ones such as ARB, BRG, CAR, COH, CSL, REA, REH, WES etc. but these kinds of businesses have at least several of them.)

Now let's evaluate SRG according to that checklist:

Non-cyclical and recurring revenue streams? YES/NO
It's a cyclical business, dependent on infrastructure spending patterns and the cyclicality of the engineering construction industry. And while they have moved into the more annuity-like industrial maintenance area, SRG's business model is heavily project based, so it has lumpy revenues which are certainly non-recurring (SRG need to continually replenish it's project pipeline)

Granular customer base? YES/NO
Not really. At any given time SRG has a few large projects on the go and if just one or two of them go bad, it can impact profits hard.

No dependency on critical business inputs? YES/NO
SRG gets a tick on this point. The inputs into its business, i.e.. technical skills, blue-collar labour and industrial equipment, are generally readily accessible.

Non-commoditised service offering with limited competition resulting in pricing power? YES/NO
What SRG does for a living is not unique or differentiated and plenty others do it equally well. As a result tendering is competitive and scope for exercising pricing power is very limited.

Easily scale-able, requiring limited capital to grow? YES/NO
SRG doesn't scale well. It is dependent on continuously being awarded new contracts to replace the ones that get completed. While it isn't easily scaled, on the positive side, when its top line does expand, it requires only a modest amount of additional physical capital (plant and equipment), and its incremental working capital requirements are low, too.

Capital-light with high asset turnover? YES/NO/NEITHER
SRG is only a moderately asset-heavy business. It has around $600m worth of Assets to support Revenue of $800m, so the assets turn over just 1.3x to 1.4x each year, which is not too bad. Anything around 1.5x is acceptable, in my experience.

High gross and operating margins? YES/NO
While SRG is not excessively capital intensive, it is people-intensive (effectively, it is a technical services business which makes a small margin on its employee base). Accordingly, SRG's EBIT Margin is a mere 5% to 6%, and the NPAT Margin is a skinny ~3%.

[Note: It is worthwhile pausing, at this point, to consider Return On Assets (ROA) which is a widely used indicator of the quality of a business. When dealing in operating performance ROA can be defined as EBIT/ASSETS.

We can decompose ROA into its determinants, being the product of Asset Turn and EBIT Margin, i.e., derived as follows:
ROA = ASSET TURN x EBIT MARGIN
= (REVENUE/ASSETS) x (EBIT/REVENUE)
= EBIT/ASSETS (because the REVENUE's cancel each other out)

So ROA has been shown to be a function of the level of Asset Turn and EBIT Margin

In SRG's case, Asset Turn is decent, at around 1.4x, but EBIT Margin is crappy, at ~5.5%
So SRG's ROA = 1.4 x 5.5% = 7.8%, say 8%. Which is pretty mediocre.

Conservatively struck financial accounts, containing prudential padding? YES/NO
Like all engineering construction business with large contract assets, where the life of a project or contract doesn't conveniently match the 6-monthly and 12-monthly reporting cycle, the financials tend to be hard to assess for their veracity. Case in point, timing differences mean the cash flow statement reconciles poorly with the P&Lin any given financial period.

CONCLUSION:
While this is not the most definitive study, and I don't presume to possess any monopoly on assessing business quality properly, I find this sort of approach has served me well.

But hopefully it provides some idea how I come to view SRG is far more "gnarly" a business than a beautiful one.

If I was to crudely score the business, on a scale of 1 = Rubbish and 10 = Beautiful, then it would rank as 5.5. Which is why it will always be afforded a meaningful discount valuation by the market.

As a result, I feel that the business will probably be more valuable in the hands of a larger company than as a publicly-listed entity... which I happen to think is the end game for SRG.

But that's a story for another time and place.

.