Disclosure: I have an interest in Judges Scientific shares
Judges Scientific – in your author’s humble opinion – is one of the best companies on AIM. How do we define ‘best’?
Here’s the share price performance over the last 10 years, overlayed with the normalised diluted earnings-per-share. The first measure shows how the market perceives the company. The second shows their delivery in growing shareholder wealth in a more tangible way.
As the caption at the bottom shows you, Judges has a phenomenal track record. I spend most of my waking hours looking for companies that compound wealth in this way, and I don’t find many. Assuming that the history of the company has whetted your appetite, we’ll go a step deeper.
To start with what Judges isn’t: Judges is often described as a ‘roll-up’ company, but to do so tars them with a brush which I think is a little unfair. Roll-up strategies typically entail a player consolidating a fragmented industry by buying a number of competitors and trying to extract synergies from the scale that you derive this way. Judges does not do this. Judges is more like an investment company a la Berkshire Hathaway. The Judges Scientific entity itself acquires small scientific instrument companies and then allows them to run independently. The corporate level acts more as a capital allocator, a unified market entity and a provider of financing than anything else.
What Judges is, is a home for small, monopolistic, high-return scientific instruments companies. There are lots of these in the UK, predominantly because the UK is a world leader in research institutions – Oxford and Cambridge to name but two. These attract world class scientists, and world class scientists or engineers often find themselves setting up businesses catering to the niche in which they are qualified. After 20 years of running these businesses, entrepreneurs need an exit. A stock market listing is not a viable option – they are sub-scale, on their own – and private equity find them either too small or too esoteric. In steps Judges Scientific.
Their model (detailed in their corporate presentation, freely available on their website) is to identify the most resilient of these businesses – typically with a very high percentage of sales exported, and with few or no competitors – and pay 3 – 6 times EBIT for them. This provides an attractive exit for the entrepreneur and an attractive price for the company. They finance the deal with a slug of debt – 2.5x EBITDA is their stated cap, which practically works out at between a third and a half of the acquisition cost – and the process repeats itself. Today, Judges has ten subsidiaries, though one of them mostly works as a service provider to the rest of the group.
The execution of a strategy like this relies on competent and honest management who are able both to accurately appraise the value of the small companies they come across and then buy them at a price which works both for shareholders and for the seller. We have a few data points on this:
- The track record of the company is the most obvious one; their competence is evidenced by their success thus far.
- The management team – CEO, FD and Chairman – remained exactly the same from 2005 to this year, when the FD retired and Brad Ormsby was brought in.
- The salaries the board takes are very low for a listed company of its size – £546k total remuneration for the entire board for a £100m market cap company. David Cicurel, the CEO, didn’t take a salary for much of the company’s early history.
- Depending on how you want to define it, the board and family/friends own 20%+ of the outstanding share capital.
- The recent acquisition of Armfield is also telling, because it was partly settled in shares. Judges pride themselves on honouring the heads of terms they sign for acquisitions, and not nickel-and-diming as is often accused of private equity buyers. This might explain the reciprocity that we see when Armfield agreed to be paid in shares at a price of 2055p per share (the price when the HoT was signed) – 25% higher than the price of the shares when the deal actually completed.
Having met management, I also appreciate their focus on return on investment, because it is exactly what drives a business like Judges – they are keyed into the right things, understand what drives their performance, and repeat their mantra with zeal.
When I think about Judges, I think about it in the framework of buying two assets. I am buying the existing businesses as they stand today, and I am buying the corporate entity and management’s track record of creating value through acquisitions. The sceptic would say that the first of those is what really accrues to shareholders, because the second is both unpredictable and subject to more unknowable risk. The management team could pack up and head to Barbados tomorrow. I’ve outlined in the section above why I think that isn’t likely to be the case, but prudence is a sensible approach.
So let’s look at, and think about the value of, the underlying businesses in the Judges family. To pick out three as examples for flavour:
Sircal Instruments make purifiers for Argon and other noble gasses. High level purity argon is needed for arc spark spectrometry, which is used for analysing the composition and purity metal of samples for steel mills, dealers and so on. A chunk of the business’s revenue comes from consumables. On acquisition, the business was earning 40%+ EBIT margins.
Fire Testing Technology creates instruments which you can use, basically, to test the flammability of objects under certain scenarios. The level of heat generated, the pace at which fire will spread and the quantity and composition of smoke can be measured.
Armfield is the company’s most recent acquisition. Three quarters of its revenue comes from the education sector, with the rest coming from industrial R&D machines. Products include a rainfall simulator (used to measure soil erosion, among other things) a series of what can only be described as ‘engines in perspex boxes’, and some much bigger kit – including a large tunnel which can measure how water will flow and affect silt beds.
There are two observations one can draw from looking at their businesses. The first is that they are predominantly public sector led, by either research or education. The second is that they are very niche, which probably goes some way to explaining their extremely high EBIT margins. The subsidiaries seem to have grown revenues at a high single-digit rate upon subsumption into the broader group, which doesn’t hugely surprise me. The broad categories of testing, measurement and analysis seem likely to be growth sectors in the world generally.
On aggregate the businesses Judges has acquired, as of last FY figures, required a total of £26m of tangible capital to run – if you include the entirety of the cash balance – to produce £7m of EBITA. The flow-through to equity cash flow should be helped by the tax benefits of significant amounts of amortisable intangible assets (customer relationships, trademarks etc.) that the accountants ascribe to the businesses upon acquisition. This is an exceptional return on tangible assets, and I suspect understates the return on incremental capital in these businesses. I suspect future growth will require very little additional investment beyond a splash of working capital and the occasional increase in capacity, as recently occurred.
Around 20% of the group’s revenue is earned in the UK. 80% is exported – 30% represented by Europe, 20% by the US/Canada, and 30% by the rest of the world.
Of course, it’s not all a rose garden, or we wouldn’t be here. After an unblemished 8-year track record of increasing returns and EPS, last year broke the trend. Softness in order intake flowed through to weakening revenue and earnings, and the timing – coinciding with the year following the completion of their largest ever acquisition and adverse exchange rate effects – fuelled some speculation that their model was simply too difficult to scale.
I think one should expect some noise in sales, particularly public sector sales. I also think that – if you believe they are fairly leveraged to public sector spending – now is certainly not a cyclically strong point for their end-markets. Some comfort can be gleaned from the fact that the sales declines were not limited to one geography or one division of the business – which might have led to the conclusion that one of their businesses had a structural issue.
In aggregate, the combined effect of this softness was reducing 2013’s pro-forma EBIT (after adjusting for the timing of acquisitions) from ~£8.6m to ~£7m in 2014. Once you then add in the Armfield acquisition completed early this year, adding ~£2m of PBT, you get to a run-rate PBT figure of around £9m, down from a £10.6m peak.
You can have a discussion about which figure you want to apply a multiple to. Perhaps you think the currently implied £9m run-rate is still too high, and further weakness is in the works. Perhaps you think the currently implied £9m is too low, and we’re at a cyclical low point for spending on testing equipment. I don’t have a huge amount of confidence in either argument. Regardless, given the high-quality nature of the businesses, the exceptional incremental returns on capital, the geographical diversification and the underlying growth trends, I don’t think 14x would be at all an expensive multiple to pay.
Even on the lower £9m figure, they trade cheaper – and their peers, for what its worth, trade punchier than this:
At 12x EBIT, I think Judges is a very high quality business at a very undemanding valuation. I think this is a poor way of valuing the business, but it gives us a reasonable baseline – if I assume that the business is worth 14x for all the characteristics I described above, we have another ~15% fall in run-rate EBIT the stock can absorb before it becomes expensive. And, again, I think you have to make some pretty bearish assumptions to slap on a 20% fall in earnings, and then an additional 15%, and call that the ‘run-rate’ – unless, of course, you believe the market was for some reason structurally over-inflated in 2013 and prior.
Point-in-time multiples fail to capture the value creation in a business which is reliant on investing increasing amounts of capital at a high rate of return, and so I use the above methodology as a fall-back sanity check, and not as my determination of what the company is actually worth. For that, you need to think about more things. You can condense it down into 4 key metrics:
- The rate of return in the existing businesses
- The amount of growth in the existing businesses
- The rate of return on acquisitions
- The amount of capital the management team can deploy on acquisitions
There is an intuitive way of thinking about why the amount of capital deployed makes such a different to the valuation; simply consider that if Judges acquires £1.5m of EBIT for 4x (£6m) and rolls it into a larger group structure trading at 14x (£21m), the group as a whole is worth £15m more. Some people have a gut-led suspicion of this voodoo, and I empathise with that viewpoint – we have all seen plenty of businesses executing roll-up strategies which fail to show any return for shareholders. The difference is that Judges have a track record of already doing exactly that, easily measurable by simply the incremental capital they’ve put into the business and the resulting increase in EBITA, and that they have a strategy which credibly explains why they’re able to add that value. If it helps, you can compare the way Judges creates wealth to the very way I’m trying to by investing in Judges – I am identifying and purchasing assets at a lower multiple than their fair value to the enlarged group.
With that aside, a very simplified version of that model looks this:
This one leaves out modelling the effect on net debt (beyond seeing that it is perfectly feasible, which it is). Food for thought on the scenario outlined above includes:
- Using £7m as the baseline EBIT figure for the core business ex-Armfield. If you believe last year’s slowdown was a cyclical low, this is too harsh.
- Assuming £10m of annual acquisition spending. The future will be more lumpy than this. The group has already spent £10m so far this year, spent none last year, and spent £12m the year before that. The group has a significant amount of financing capacity at the moment, which grows with its EBIT-base.
- Assuming a 20% rate of return on investment spending, which equates to a 5x EBIT multiple. Historically, the group has acquired cheaper than this as a weighted average. One might expect it to be dragged higher with larger deals, though, perhaps even beyond 6x (16.7%).
- The effect of debt and the increase in equity returns is ignored here
- The 4% rate of growth assumed, arguably from a low base, in a group which historically tracked at mid-high single digits.
If you’re interested in Judges, I think it’s incredibly enlightening to make a model and play around with the assumptions therein. I am slower than most, so it takes modelling scenarios to really get to grips with how and what will really drive the business.
For what it’s worth, using assumptions I think are realistic but neither particularly aggressive or conservative, I think Judges can get to £40 a share within 4 years. The tail-end of that CAGR would give a ~24% return on my investment, as well as a percentage point or two of dividends annually.
And for those who don’t like all of the hypothesising above, think about it this way; you’re investing, alongside management, at ~11x EBIT, in a team with one of the best records of value creation on the London stock market.
I see it as an asymmetric bet; you’re buying a collection of underlying business with above market growth, above market returns and exceptional margins at a cyclically undemanding point. A mini – but better – Oxford Instruments – at a much cheaper multiple. This protects the downside of your distribution. The up case comes if management continue to create ongoing value from accretive acquisitions. Given everything I’ve said so far, I think the skew on this distribution is heavily in investors’ favour.