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In complete honesty, that was probably the best post I've ever...

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Wini

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27/02/16

13:32

Post #: 17132918
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Originally posted by madamswer ↑

@Wini,

Thanks for the analysis of the result.

You have picked up on some really important features of the result.

I have to say that, for such a little company, the financials have a lot of separate elements that need to be analysed in order to come to a view as to the overall quality of the result, and to therefore come to a view of how the underlying business is performing.

When I first scanned through the result, I was a bit disappointed:

While Revenue growth of 10% was bang in line with what my financial model suggested, reported NPAT was about 5% lower than my modelled forecast, and EBIT and Pre-Tax Profit were around 4% lower.

Specifically, Depreciation and Amortisation jumped sharply in the half, being up 36% on pcp, and "Other Expenses" jumped almost 75% on pcp.

That the company's bottom-line grew by only 10% when it had several tailwinds supporting it (the significantly weaker A$, traction in Brazil, improved trading conditions in Europe), I thought was a bit ordinary.

But when I read the accompanying commentary and came across the $0.6m in NRIs that were booked above the line, I was a bit more heartened.

Certainly that figure explained the dramatic increases in D&A (where the write-down will have been recorded) and the "Other Expenses" line, where I assume the restructuring costs were allocated.

Because I have not been able as yet to confirm it, I have arbitrarily added back half the $0.6m to D&A and the other half to "Other Expenses" in order to arrive at a more normalised P&L for the half.

Below follows growth rates in various salient P&L line items comparing them as reported by the company with my "normalised" figures:

EBITDA Growth
Reported = 15%
Normalised = 20%

EBIT Growth
Reported = 6%
Normalised = 22%

Pre-Tax Profit Growth
Reported = 8%
Normalised = 24%

NPAT Growth
Reported = 10%
Normalised = 25%

So, the underlying profit result is a lot stronger that it appeared at first glance.

And while 25% earnings growth indeed does seem more than satisfactory, I think that even this figure understates the true positive financial momentum in the business, as I discuss below.

Analysing the individual operating cost elements in a bit of detail is quite illuminating.

At first glance my financial modelling of operating costs at the aggregate level was remarkably accurate (I had forecast $28.78m; they came in with $28.28m (pre-NRI's, of course).
That's a forecast error of less than 2% (!) (I must be a very good modeller with really keen insights into, and understanding of, the company's operations.

Trouble is, and it’s a bit embarrassing, I got it right for all the wrong reasons:
I was 20% too high on “Cost of Sales” (CoGS) [excluding D&A], and 11% too low on "Selling and Admin Expenses" (SG&A).

In other words, I got it right but for completely the wrong reasons.

I just happen to have made some perfectly compensating errors.

Starting with the first one, CoGS (and, therefore, GP Margins):

One of the major takeaways from this result is something that has been talked about for some time. but this is the first time I've seen the real effect of it.
And that is the opposing dynamic on Revenues of a declining, legacy "olde worlde", amalgam business on the one hand, and a growing, "new age" composite, ionomer and whitening products business on the other.

The ascendancy of the “new age” business (which has a less commoditised product offering and therefore more pricing power) has become evident in the Gross Profit Margin, which at 68.2% for the DH2015, is significantly higher, being up 400bp on pcp and 760bp up on JH2015, and is the highest it has been for a decade.
(No doubt that a slightly lower silver price and a significantly weaker A$ has had an impact here, but the trend in rising GP Margins began some time ago when the A$ was a lot higher, so it is certainly not just currency related.)

And sure, one swallow doesn't make a summer, so it will be interesting to see what the GP Margin does in future financial periods; if it is indeed maintained at current levels, then something that has exercised my mind about this business in the past is the extent to which it can transition from being a supplier of a largely commoditised product, namely amalgam, to a range of products that contain some unique and differentiated intellectual property - borne out of the $10m that has been invested in R&D and the $17m for the acquisition of IP-related intangibles over the past decade.

For it is only when you have some sort of unique product offering that is like no other that you can engender brand equity, from which you can command some pricing power.
Given the uptick in GP Margins in recent years, it looks like this may have started to take hold, and this latest reported GP Margin serves to confirm that.

And a cumulative total of $27m of Intellectual Property related expenditure is a very material sum of money in the context of a company that has a $63m market value today.
There would be very few profitable corporations today that would be valued at a little more than just double their non-goodwill intangible assets. For most, the multiple of market value to Non-Goodwill Intangibles would be in the double-digits.

So, either SDI management has wasted a lot of that R&D capital, or that IP will increasingly come more into its own in terms of earning its keep by generating faster growth and higher returns.

If the current elevated GP Margin can be sustained, and indeed improved further as sales of the “new age” products increasingly outpace amalgam sales, then this will prove to be a meaningful driver of future earnings.

And this is a somewhat nuanced aspect of the P&L, so I doubt if the market fully appreciates the extent of this dynamic.

Next, dealing with the big jump in "SG&A Expenses":

I suspect most followers of companies view operating costs as bad things which need to be reduced.
But there are some costs that are actually necessary - and indeed - "good" costs.

At the risk of sounding like I'm wearing my spectacles that allow me to see only positive things, I believe this to be the case here in terms of the large SG&A expense increases.

It is clear that this jump in costs is almost exclusively to do with establishing administration infrastructure and expanding the company's profile in South America ahead of a distribution push there, as well as in the US and Europe as part of a drive in these regions to market the company's "new age", high IP, branded products - as opposed to "olde world", commoditised amalgams.
I am certain that very little of the increase in group SG&A can be attributed to Australia.

Which means that there is a bit of a mismatch between current levels of Revenue and current Operating Costs; there is a significant investment underway in sales and distribution capability, ahead of the Revenue curve.
Over the last 1 and 2 years, there has been a 13% and a 21% increase, respectively, in SG&A expenses.
That rate exceeds the rate of Revenue growth over those periods.

In fact, I believe that one of the most striking aspect of SDI’s financial performance over recent times, and something that is a significant leading indicator of future performance – and it is something I am convinced few people care to consider – is the differing dynamic of the two elements of the company’s cost structure, namely CoGS on the one hand, and SG&A Expenses on the other.

For no matter what the time frame is that one is evaluating (1, 2, or 3 years), there is a large dispersion in the direction of CoGs and SG&A Expenses, as shown below:

1-Year
Total Operating Costs up 7%
CoGS down 3%
SG&A up 13%

2-Years
Total Operating Costs up 6%
CoGS down 6%
SG&A up 16%

3-Years
Total Operating Costs up 20%
CoGS up 1%
SG&A up 41%

(For context: Note that CoGS today represents 38%, and SG&A represents 58%, of Total Operating Costs)

Now, of course, because SDI reports in A$ functional currency, exchange rate movements may have had some distorting impacts on these respective line items but the broader conclusion of:

Increases in Operating Costs have overwhelmingly been only due to increasing SG&A expenditure,
…as opposed to CoGS, which has basically remained constant for 3 years (despite strong Revenue growth).

(I have written this in bold font, because I think it is fundamental to really understanding what an investment in SDI is all about. It is the single most important factor.)

The way I interpret this significant and growing investment in Cost of Doing Business, is that the company’s management is investing for growth.
…. even if this has resulted – while the company lacks the sufficient scale in the offshore markets being targeted – in a drag on overall financial performance in the short term.

For some context on the scale of this earnings drag: for every 100bp lower an increase in SG&A spend, NPAT increases by almost 3%.

So, had management caused SG&A to increase by just CPI, of notionally 3%, then NPAT in the last half would have been 30% higher(!) and the underlying growth in NPAT on pcp would effectively have been over 60%, compared to the 25% growth that I had calculated on a normalised basis.

This all demonstrates to me that the underlying business is actually motoring at very fast pace, but that the real extent of this is being intentionally dampened by an investment in costs to support future Revenue expansion.

Put another way, when your fixed costs – which comprise almost 60% of your cost base – are increased by 13%, and your bottom-line still advances by 25%, then you know that there is some serious operating leverage at play, and that when the investment in fixed costs is wound back, the impact on the bottom-line uplift will be quite powerful indeed.

In final summary, it took a bit of analysis before I stumbled across the evidence of it, but now that I have distilled it, I am quite confident to say that this latest SDI result is understated.
Significantly so.

Which bodes well for the future earnings.

And at a P/E of some 7x and an EV/EBITDA multiple of around 4.0, the market certainly isn’t pricing in nearly the sort of double-digit organic growth that I my analysis tells me lies ahead for many years to come.

Needless to say, I have been adding to my holdings over the past 2 days.

A useful analogue for what SDI is going through can be found in Breville (BRG), which reported its results earlier this week.

Like SDI, BRG has a mature, and declining, legacy business unit (akin to SDI’s amalgam business), and some fast-growing international businesses (the comparison with SDI would be SDI’s “new age” composite, ionomer, and whitening business, and its international beachheads)

For several years, due to the laws of small numbers BRG’s fast-growing businesses - because they had not reached critical scale, and even when they did do so - were too small in the scheme of the broader group, failed to register on the overall financial performance of the company.

But every year, the declining legacy business became less dominant and the new, fast-growing businesses became increasingly relevant, until one day the inflexion point was passed beyond which the fast-growing businesses became the biggest earnings contributors and the overall group’s growth outlook took on that of its fast-growing divisions, and its declining division no longer presented a dominant drag on growth.

The result was a dramatic increase in the underlying growth rate of the business, and therefore the valuation multiples that the market is will to pay for the stock.

Admittedly, while no two companies are the same, investors looking for a potential precedent for SDI would be well-served to look to BRG as a case study.

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In complete honesty, that was probably the best post I've ever read on HotCopper.

Absolutely brilliant, and I agree with your takeaways.

SDI Price at posting: 54.0¢ Sentiment: Buy Disclosure: Not Held
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