Disclaimer: The following is the views of the author and does not constitute financial advice. Seek professional advice before making any investment decisions. The author owns shares in SDV through the Capital H Inception Fund.
Note: If you are new to SDV it is worth reading this note first.
On the first trading day of 2020 SDV announced the acquisition of Highland Fluid Technology Inc, a US based bespoke chemistry and services company servicing the onshore oil & gas sector.
SDV Acquires Highland
Highland is well known to SDV as a customer and partner in commercial evaluations with end users, with those results announced in July 2019. In other words, Highland is the company through which SDV was planning to access the massive US oil & gas market and from which positive technical milestones had already been achieved, hinting at the possibility of contract wins.
Highland did US$7.8m of revenue in CY2019 and a small profit (my estimate A$200-$400k normalised) and will be profitable and cash flow positive from purchase. Gross margins will roughly double through vertical integration with SDV and there won’t be any need for additional costs, unless off the back of some large contract wins and expanded growth targets.
SDV paid US$6m in an all scrip deal at 60c/share with another US$1m milestone payment if Highland delivers US$20m of revenue at a target EBITDA margin in CY2020.
Why This Is A Potential Game Changer
SDV have long told the market that the game changing opportunities are in North America. This acquisition gives them an immediate presence and team in the US oil & gas market and significantly improves their odds of success and speed of market entry.
On 22/7/2019 SDV announced their chemistries achieved successful commercial evaluations with end users, selling through Highland.
These end users are enormous. We are talking $10-$30m worth of chemical sales per annum, multiples the size of the Iluka deal, which is SDV’s largest to date. Then there are a number of ‘Iluka sized’ deals in the next tier down. The scale is much greater than the Australian market.
Note that Highland vendors need to achieve US$20m of revenue in CY2020 to earn another $1m payment. This is a massive uplift on the US$7.8m revenue in CY2019.
Management believe this is very achievable. They believe this because of the scale of the contracts in this space and the early positive indications they’ve received from end users.
One contract win with a major would see them surpass this milestone. Success here would be able to be leveraged into further wins and the market would have to respond by re-rating SDV based on the much larger growth prospects in North America moving from possibility to reality.
Why Would The Vendors Sell for All Scrip?
Highland was a customer of SDV on-selling to end customers in the US onshore oil & gas industry. They have a local presence, industry-specific expertise and a skilled team.
Some of these end customers are multi-nationals and demand a certain level of safety, quality and assurance, particularly over the supply chain of their suppliers. As an integrated business, Highland and SDV (with their Nuoer relationship) can now satisfy those requirements.
The potential success for the two companies had been highlighted in the initial evaluations.
Highland have the expertise in O&G and the local presence. SDV have the proprietary technology in Optiflox and Maxiflox and, importantly, the strategic relationship and ability to scale with their supplier in Nuoer.
The Highland vendors obviously believe there is a greater likelihood of converting these opportunities as part of SDV, rather than as separate entities. They might have been able to steadily grow the business from its current US$7.8m revenue base (A$11m), but the opportunity to double or triple revenues in a short period existed in teaming up with SciDev.
They’ve seemingly backed this conviction by taking their entire consideration in equity at 60c/share.
Basic Numbers
SDV is run-rating c.A$15m of revenue and profitable. Highland brings with it US$7.8m (A$11m) based on the last 12 months, bringing the total to A$26m of run-rate revenue. The additional cost base is minimal and gross margins should be tracking in the low 30’s for SDV.
Highland Pre-Deal
If SDV/Highland are to have early success in the US oil & gas market then the US$20m revenue milestone is very likely to be achieved within the next 12 months. This would take revenue for CY2020 to >A$40m, before any further growth in the SDV core business, which is likely to keep growing.
Now we can make some basic assumptions to see what the numbers could look like for the combined group. Below we assume Highland achieves US$20m revenue in CY2020, SDV remains stable at the current A$15m revenue run-rate, gross margins of 30% and 10% growth in the fixed cost base.
SDV/Highland Post Deal
The market cap of SDV is $98m fully diluted. They have no debt and sufficient tax losses, so that c.A$6.7m of operating profit will mostly convert to cash.
If they come anywhere near these numbers then the stock is on 14-15x operating earnings, which is far too cheap given the rate of growth, size of the opportunity and leverage in the business model.
Keep in mind that while the above numbers assume success for Highland, they do not assume a full years run-rate from any new major contract wins (upside to flow in future years) or any further growth in the SDV core business.
It seems unlikely that the core business will not continue to grow, particularly given they continue to secure new trials with major customers in new industries, including the recently announced deal with MMG at Las Bambas, which is probably slightly smaller than the Iluka sized deal if converted.
Look at ANO and CLV to see the types of multiples these businesses trade on. 30x would be more appropriate. This type of upside may explain why the Highland vendors wanted all scrip.
If SDV/Highland have success in the US market then we will get the uplift in earnings but, just as significantly, the multiple re-rate as the market will start to price in further growth in this multi-billion dollar industry.
Keep in mind that the contract SDV/Highland have been looking to win is to displace an existing provider. If they can do this then the implication is that there is far more market share for them to grab.
In the initial note on SDV I mentioned $1/share as being a reasonable target. I think with this deal that target now looks achievable in the short term and far too conservative in the medium term.
Once the market realizes the potential significance of this acquisition my expectation is that the stock will begin the next leg up.
I went on a site tour of the company in December alongside Taylor Collison and just two other funds, suggesting it remains relatively tightly held amongst the larger holders and still broadly under the radar. This is unlikely to remain the case. At $100m market cap the number of institutions that can start taking a look at SDV will expand.
Management are impressive and will continue to attract institutional interest as they tell the story and execute their strategy.
Of note is that Lewis (MD) has given up some of his allotted options to the incoming new CFO (likely announced shortly) in order to attract a high-quality candidate without needing to pay more in cash to secure their services. I like this sort of thing.
The Fund has been consistently adding to its position in SDV. The Water Stocks remain a very interesting thematic.
