SDI Group: The Perfect Storm That Brought An Interesting Investment Opportunity

Funding Thesis

SDI Group (OTCPK:SDIIF) is a fallen angel inside the small caps of the UK. The corporate had achieved spectacular returns within the final decade; nonetheless, the overall worry out there, excessive inflation within the UK, the exit of investments in small caps, an impairment, and the termination of a contract that had giant revenue margins created the proper storm.

On this article, we are going to discover these important headwinds that designate the 50% drop from all-time highs and analyze tips on how to incorporate all of this into the valuation to find out if, on the present value, SDI may be thought-about a attainable good funding. Anticipating, I certainly contemplate it to be.

Enterprise Overview

SDI Group is devoted to designing and producing measurement and management devices for very various and fairly area of interest sectors reminiscent of life sciences, healthcare, astronomy, aerospace and artwork conservation. Regardless of its measurement, the corporate has a monitor report of accurately executing its progress technique during the last decade.

About half of gross sales are generated inside the UK, SDI’s residence nation. Once more, regardless of being a small firm, its income is diversified geographically.

The merchandise are segmented into the classes of Digital Imaging and Sensors and Management.

Digital Imaging

This division makes up roughly 30% of the corporate’s whole gross sales.

Inside this division, there are numerous product strains, together with Atik Cameras, that are recognized for his or her excessive sensitivity and are utilized in functions reminiscent of capturing clear pictures of deep-sky astronomy.

One other important model beneath this division is Syngene, which produces tools designed for scientists to seize pictures for protein and DNA evaluation. These examples present perception into the kind of merchandise manufactured inside Synoptics Group’s Digital Imaging phase.

Sensors y Controls

This phase accounted for 70% of the corporate’s gross sales in FY2023.

Inside this phase, the corporate operates a number of manufacturers. As an example, Astles makes a speciality of supplying dosing and management programs for chemical merchandise to beverage can producers and engineering part and engine producers. Monmouth Scientific is concentrated on offering filtration fume cabinets and installations designed to take care of clear air environments. Sentek specializes within the manufacturing and sale of custom-made electrochemical sensors primarily utilized in water-based functions.

These sensors discover functions in laboratory evaluation in addition to inside the meals, beverage, and private care manufacturing sectors.

Acquisitions

To capitalize on the extremely fragmented and specialised nature of the markets during which SDI operates, the corporate has been implementing an acquisition technique for a number of years. A good portion of the corporate’s progress may be attributed to those acquisitions, as natural progress sometimes hovers round 5%. Nevertheless, there have been exceptions in FY2021 and FY2022 (similar to the actual years 2020 and 2021) when substantial orders had been positioned for Atik cameras because of their functions in COVID-19 identification.

Whereas these orders briefly boosted natural progress and gross sales, they’re anticipated to be accomplished within the present FY2024, resulting in a normalization in progress and margins. We are going to delve into this subject additional.

SDI adheres to a well-defined acquisition strategy that it has diligently adopted in recent times. The technique contains the next steps:

• Search out worthwhile firms that generate Free Money Stream.
• Consider the monetary historical past of the goal firm to make sure its stability.
• Give attention to firms which can be leaders inside their particular area of interest.
• Search for firms with a reliable and efficient administration group in place.
• Pay a purchase order value equal to 4 to six occasions EBIT (Earnings Earlier than Curiosity and Taxes).

As soon as SDI identifies an appropriate acquisition goal and the transaction is accomplished, the corporate integrates the acquired merchandise into its portfolio. It additionally implements strong monetary controls and permits the acquired firm’s administration group to proceed operating the enterprise autonomously. By this method, SDI goals to boost the acquired firms’ gross sales, margins, and total progress by capitalizing on synergies.

Since 2014, SDI has efficiently executed 17 acquisitions following this methodology. Usually, they fund acquisitions utilizing their current web money or by taking over financial institution debt after which they repay this debt shortly after finishing the acquisition. This has been the recurring course of for the previous 8 years.

As beforehand talked about, the market is extremely fragmented, with over 2,000 potential acquisition targets in the UK, in accordance with the administration. Many of those firms had been based by people who are actually of their 40s to 50s and are in search of retirement and not using a clear succession plan for his or her companies. Consequently, promoting the corporate turns into probably the most viable possibility, leading to a constant pipeline of potential sellers annually.

FY2023 Outcomes

On September 3, SDI reported its FY2023 outcomes, which initially appeared fairly poor:

• Gross sales £67.6M (+36% YoY).
• EBITDA £11.8M (0% YoY) which represented an EBITDA margin of 17.5%.
• EPS of £0.04 (-49% YoY) and a revenue margin of 5.8%.

However beneath these outcomes lies an impairment that muddied the precise figures, subsequently, it is essential to normalize SDI’s outcomes to realize a clearer understanding of the corporate’s efficiency.

To be exact, the impairment amounted to £3.5 million. By including this quantity again to the reported income, we arrive on the following figures:

• Gross sales £67.6M (+36% YoY).
• EBITDA £15.3M (+30% YoY) which represented an EBITDA margin of twenty-two.7%.
• EPS of £0.07 (0% YoY) and a revenue margin of 11%.

The outcomes are usually not as dire as they initially seem, and I’d even enterprise to say they’re fairly optimistic. The problem the corporate faces is that, for this fiscal 12 months, they’ll expertise a lack of roughly £8 million in income from high-margin Atik digicam contracts. Subsequently, it is essential to take this issue under consideration within the valuation, as we are going to discover shortly.

It is important to focus on that an impairment isn’t a good prevalence, because it signifies that the board might have overpaid for the acquisition of Monmouth. Nevertheless, it is reassuring to notice that such impairments don’t seem like a recurring concern for the board, which is a optimistic facet given their historical past of 17 acquisitions over the previous decade.

Key Ratios

The corporate has achieved outstanding progress, with an annual improve of 27% between 2017 and 2023. Moreover, throughout this similar interval, EBITDA has grown by 35%, and Free Money Stream has surged by 55%, indicating enhancing margins.

A more in-depth look reveals that the expansion within the EBITDA margin has been gradual. Nevertheless, within the case of Free Money Stream, there was explosive progress in 2021 and 2022, adopted by a normalization in 2023. This pattern aligns with the contracts for the Atik cameras, which had been probably executed with very favorable margins.

The corporate’s means to realize a 15% common Return on Capital Employed and the same Return on Free Money Stream invested is a key metric for assessing the effectivity of SDI Group’s acquisitions, on condition that acquisitions characterize the first use of capital.

From 2018 to 2022 (FY2019 to FY2023), the first sources of financing had been money from operations and debt, in equal proportions, as beforehand talked about. Capital was predominantly allotted to acquisitions and repaying the acquired debt.

This method is evident: use debt for acquisitions and subsequently pay that debt with generated money. Nevertheless, with current will increase in rates of interest, it will likely be important to observe the corporate’s monetary place. Extremely leveraged conditions might require a pause in acquisitions sooner or later.

By way of solvency, the corporate possesses practically 2 occasions extra property than whole liabilities, indicating that it has the capability to promote its property to cowl all liabilities twice over in case of debt points.

Concerning liquidity, SDI maintains 1.7 occasions extra property than liabilities, signifying that it’s in a robust monetary place to satisfy its short-term obligations and money owed.

The Web Debt/EBITDA ratio, nonetheless, is displaying an upward pattern 12 months after 12 months, though it stays at a manageable degree of 1x EBITDA. Monitoring this ratio to make sure it does not method 2x ranges within the coming years can be vital.

It is vital to notice that these knowledge are adjusted for the talked about impairment, permitting us to gauge the underlying enterprise efficiency with out the noise generated by this accounting adjustment, which does not entail a money outflow.

Valuation

For the valuation, it is essential to contemplate a normalized surroundings of progress and margins. Administration anticipates making 2 to three acquisitions throughout FY2024 and expects a lack of roughly £8M because of the Atik digicam contracts. The corporate sometimes experiences natural progress starting from 5% to 10% and for this 12 months the target stays the identical.

(Supply: Final Results Investor Presentation)

Moreover, with the lack of contracts that includes exceptionally excessive margins, it is prudent to scale back the EBIT margin to the historic ranges of round 15% that had been prevalent previous to buying these contracts. It will present a extra reasonable foundation for the valuation.

In FY2023, the corporate made 2 acquisitions contributing £17.5 million in income (roughly £8.75 million per acquisition). In the event that they make one other 2 acquisitions within the present 12 months, I may estimate £15 to twenty million in gross sales. Nevertheless, to be conservative, let’s assume they solely make an £8 million acquisition, and natural progress stays at 0% because of recession issues. Thus, FY2024 web progress could be round 0%.

Following this difficult 12 months, it is cheap to count on the corporate to return to its typical progress trajectory, however we’ll contemplate a extra conservative 15% progress charge as a substitute of the earlier 27%. For exit multiples, we’ll use 12x EV/EBITDA and 15x EV/FCF, in step with historic ranges earlier than 2020.

With this conservative valuation, it is attainable to estimate a compound annual return of 15% from present costs if bought from the London Inventory Change since valuation might differ barely if bought OTC.

Dangers

Curiosity Charge Fluctuations: Adjustments in rates of interest can considerably affect the price of debt and subsequently will have an effect on the corporate’s means to make acquisitions, except SDI decides to sacrifice monetary power with a purpose to proceed rising inorganically, which I’d contemplate very dangerous.

Integration Challenges: Efficiently integrating acquired companies may be advanced. Cultural variations, expertise integration, and administration alignment can pose important challenges and whereas the corporate has an excellent monitor report of doing this correctly, it’s nonetheless a danger to contemplate.

Market and Expertise Danger: The measurement and management devices trade could also be topic to speedy technological developments. If the acquired enterprise operates on outdated expertise, it could develop into out of date shortly and progress and synergies could be worse than anticipated.

Ultimate Ideas

The corporate’s present situation justifies the current drop in its inventory value, however I’ve chosen to take a conservative method in valuing it. Regardless of its challenges, the corporate stays well-managed with a robust monitor report, wholesome revenue margins, and a excessive return on capital employed.

Debt ranges would require shut monitoring, however I imagine the corporate has the potential to realize 10% annual progress within the coming years with out requiring important debt that places SDI in danger. Subsequently, I am giving it a “purchase” ranking whereas protecting a watchful eye on its monetary scenario.

Editor’s Observe: This text discusses a number of securities that don’t commerce on a significant U.S. trade. Please pay attention to the dangers related to these shares.