The Real Extent of the Amalgam Drag

Much has been said and written about the fact that SDI's amalgam sales have been under pressure in recent years, but I don't believe that the market really fully appreciates what has been going on under the surface in terms of SDI's organic earnings trends.

So I think it is useful to conduct a bit of an exercise into what has really been happening over the past few years and how this informs the nature of an investment in SDI, going forward over the next several years.


Recall that amalgam constituted around 45% of SDI's Total Revenue in FY2013 (which is the first period for which the company has provided the Amalgam component).  By FY2018, it had fallen to 26%.

This means that, in A$ terms, revenues from the sale of amalgam have declined from $25.5m in FY2013, to $19.4m in FY2018 [corresponding to row (B) in the table below]:  





As can be seen, amalgam sales have declined by some $6.1m in nominal A$ terms, equivalent to 5.3%pa compound annual contraction.  

So, while SDI's revenues have grown at a CAGR of 5.7%pa, it has been the 12%pa CAGR in the non-amalgam sales revenue that has more than offset the contracting amalgam sales.


But those diverging trends have been distorted by the reduction in the A$ exchange rate over that period, from 1.02 to 0.77, the consequence of which is to flatter the underlying growth in constant currency, non-amalgam sales, but it also understates how severe the fall in amalgam sales has been in US$ terms, the currency in which most of SDI's sales are invoiced.

Presenting the above table in US$-equivalent terms, shows the reduction compound annual contraction in amalgam sales running at around 10.5% [refer the red shaded area in row (E)]:



Overall, amalgam sales revenue, in US$ terms, has fallen by a whopping 42% over the past 5 years!
That is a very big deal.


Importantly, however, non-amalgam sales revenue in US$ terms has been rising by 6%pa.

The reason this is a figure worth highlighting is because as amalgam sales continue to become proportionally smaller, the laws of arithmetic mean that the growth of the company's overall revenue increasingly approaches the growth rate of the fastest-growing component, i.e., 6%pa.

And a company with SDI's P&L structure, and growing Revenues in constant currency at 6%pa, will see bottom-line earnings growing organically at around 12%pa to 14%pa.

So, even if the stock fails to re-rate from its current P/E multiple of less than 13x, but simply maintains it, an investment in SDI today - even after the share price has doubled over the past 12 months and is close to a 14-year highs - will deliver a total  annual investment return of around 15% to 18%pa (12%pa to 14%pa capital appreciation, in line with the EPS growth, plus 3% dividend yield).



Another way to look at this situation, and what it possibly implies for the shape of SDI's future earnings trajectory, is to try to quantify the foregone Revenue and EBIT due to the contraction in amalgam sales.

To do this, consider the preceding table (the one presented in US$ terms) and construct a theoretical Total Revenue estimate, assuming amalgam sales had been unchanged under the review period, and then estimate to what extent SDI has foregone revenue that would otherwise have accrued).  (Refer following table.)

From the preceding table, take FY2013's amalgam revenue level of US$26m and add it to non-amalgam revenue in each year subsequent year, to get the "Theoretical" Total US$ Revenue for the company [row (G)].

From this, calculate the "Theoretical" Total A$ Revenue [row (H)] by converting at the average exchange rates for each year.

The difference between this "Theoretical" Total A$ Revenue and the actual reported A$ Revenue [row (A) in the first table] is the Foregone Revenue [row (I)]:




So, had amalgam sales revenue held up, the company would have been generating some $14m more revenue today that it is currently doing, and the revenue increase between FY2013 and FY2014 would have been around $32m, instead of the actual $18m (in US$ terms it would have been $10.8m higher, instead of merely flat).  

And, as a proportion of actual revenue, that $14m difference amounts to a significant 19% of FY2018's reported revenue.


The next logical step is to translate this foregone revenue into what it would have meant for earnings.

Applying the company's 60% Gross Profit Margin to the $14.3m in lost sales yields an incremental $8.6m of Gross Profit and - assuming no material additional fixed costs required to deliver that additional revenue - an extra $8m-odd in EBIT.

That is a highly material quantum in the context of the company's actual EBIT of $8.3m achieved in FY2018.




CONCLUSION:

1. The "amalgam effect" has had a very material impact on SDI's financial performance over the past 5 years.

2. With this now becoming a less important factor, going forward, the "true" financial pedigree of SDI is expected to become evident.

3. Without any future re-rating of the stock (unlikely, but assumed for argument's sake), total annual investment returns in the mid teen percentages are on offer.



NB. This is not intended to be the definitive study the finances of SDI; rather it is intended as an indicative exercise to provide some insights into the mathematical mechanics for what SDI's future financial performance is likely to look like as amalgam reduces, at an exponential rate, its drag on SDI's revenue and earnings.


Of course, when 90% of your cost based is located in one location and denominated in one currency, but 90% of your sales are invoiced in different currencies, then relative exchange rates, notably the A$, will always have material impacts on near-term financial performance, but the company will grow earnings through the cycle.

As case in point, the company will this year almost surely report record earnings and, based on the current prevailing exchange rates, is highly likely to report record earnings again in FY2020, I strongly expect.

And that outcome is despite the very significant headwinds from the sharply declining amalgam revenues, which I estimate will next year be half of what they were in FY2013.

When the revenue from something (amalgam) that made up almost half of your total revenue at one point in time, halves in size over a period of 6 or 7 years, yet - despite that - record revenues and profits [*] are still achieved, then that is objectively quite some statement about the quality of the underlying business.

Because SDI is a small and illiquid stock and is not very widely researched, I have a strong sense that the overwhelming majority of investors don't really appreciate what is happening with the earnings drivers of the business.


[*]  despite the A$ being only around its long-term average level.