Disclosure: I have an interest in Judges Scientific shares
I last wrote about Judges Scientific about 6 months ago, in May. There, I laid out the case for why I think it is one of the best companies on AIM, and why I thought the price was undervaluing both the business as it stands and, more importantly, the potential for the management team to continue enriching shareholders through their well-worn acquisitive strategy.
The day before that post, the price of Judges shares was £17.40. Today, the price stands at £15. In this post I will walk through what has happened in the interim, along with an updated valuation. The short summary is that the group has reported good news on order book, the best leading indicator of sales we have, and has proven that the latest acquisition they have completed was still as accretive as in previous years. It is thus both cheaper and more valuable.
A quick recap of the elevator pitch: the company buys small, niche scientific instruments businesses as they come to the end of their private lives. They then let these companies run with a great deal of autonomy, with the central hub’s main purpose being capital allocator for future deals. This is interesting for three reasons:
- The UK has a large number of small scientific instruments companies due to the existence of world-class education institutions. Smart people find a niche that needs to be satisfied, and start a business to satisfy it.
- Said businesses have superb characteristics – exceptionally high margins (Judges runs at 20%+ on a consolidated level), low incremental capital employed – and hence excellent cash flow profiles, and tailwinds from increasing global research and education spending (China is a big boost to this). They typically export the majority of their revenues and have limited meaningful competition.
- Judges is small enough to buy the small ones and still have them move the needle. They can hence provide a home for excellent businesses while still being picky about price.
They typically pay between 3-6x EBIT. The streams of cash flows they generate, when aggregated together into a more sizeable business, financed with a bit of leverage to juice returns and with earnings reinvested in the same way, has compounded returns enormously for shareholders in the company. Your opinion of management is crucial since you are betting on their capital allocation to add value above and beyond the collection of assets as it exists today. That’s one you have to make your own mind up on, but their track record and attitude are superb.
You pay, if you believe my numbers, 11x forward earnings (by which I mean not the year ending in 3 weeks, but the one after). I think the assets in the business as it stands today are worth more than this even if the company dividended out the entirety of their cashflows. The fact that they do not – and instead reinvest them at 25%+ levered rates of return – is where the real upside potential comes from.
I said at the top that a good deal of comfort comes from the fact that the latest acquisition seems to have been as accretive as promised, and as prior deals. Here are the basics of that transaction:
- £8.28m paid for the company
- £1.51m earn-out for operating performance
- Some open-tailed pension liabilities and working capital adjustments.
The deal was clearly struck on a 5x EBIT basis. £8.28m is exactly 5x the pro-forma EBIT (£1.66m) for the group having adjusted for its ongoing cost-base under the Judges umbrella. The £1.51m earn-out is based on outperformance and is capped at a total consideration of £9.8m, or 5x the maximum earn-out profit figure of £1.96m.
On May 22nd, the company announced that the entirety of the earn-out was attained and settled, partly in cash and partly in shares. The deal actually looked slightly sweeter from an accounting perspective, because the half that was share-settled was calculated using the share price at the time the deal was first negotiated (£20.55) and not the then share price (£16.825).
So the group ended up paying ~£9.65m for a business which earned ~£2m of EBIT. It financed this using £4m of debt and £5.65m of equity. If you assume a 5% interest rate on the revolver they used to fund it (they don’t disclose the rate) and a 20% tax rate (too high, but we’ll leave it) this works out at a pro-forma 25%+ return on the equity invested.
So far, so good.
What’s better is that incremental capital invested in this business will earn returns on equity of significantly above this. We know that the group was earning £2m of EBIT on £3m of net tangible assets on acquisition, of which £2.6m was cash. Even assuming none of that cash is surplus to requirements, which is clearly wrong, you are left with incremental RoEs of 50%. With incremental returns this high, it would be great if Armfield were growing.
… which it looks like it is. You can play around with several data points the company gives out in their half yearly results statement. My interpretation is that this year might not be quite as strong as last for Armfield (big projects made before the earn-out, perhaps?) but order intake is running significantly ahead of budget and prior comparative periods; so the future looks good.
The rest of Judges is also improving, albeit with a bump in the road – recent numbers were pretty weak.
I care more about order intake than I do about revenue because revenue is a lagging statistic. Order intake, assuming there is not significant leakage, is a better indicator of where the company will be in six months time, and what it will earn. Hence, I was surprised when the stock sold off with the weak headline numbers in September. That should have been priced in – they were already a given, because we had already seen slowdown in the order intake. What was new and interesting was that order intake had accelerated rapidly.
In the group’s corporate presentation, available on their website, you will find the following graph:
In the group’s press releases, they also make some comment to the underlying data:
“These results, of course, are the predictable consequence of the Group’s order intake history since the beginning of 2014. Organic order intake was weak throughout the first three quarters of 2014 and during the first quarter of 2015. The last quarter of 2014 was positive and the second quarter of 2015 was strong. In the first half of 2014, the Group maintained sales but at the expense of the order book which declined from 10.9 weeks to 7.8 weeks. The order book subsequently recovered in H2 2014 to 9.9 weeks at the year-end. The recovery in the order book has continued to progress, despite a weaker Q1 2015, with the order book rising to 11.7 weeks at the period end. As explained in the recent trading statement, reduction/improvement in the order book has a significant positive/negative impact on earnings respectively. Your Board estimates that a one week movement in the Organic order book currently equates to approximately 6.5p in earnings per share in respect of the period; comparative results should be seen in that perspective.”
The big positive is that recent order intake (for the last 4 months) has been significantly more than the budgeted level. This has some impact on the back half of this year. If the trend continues, it will have a much greater impact on next year.
Either way, this is a significant positive data point since I first wrote about Judges. At that point, the company was in the trough of order intake with no sign of improvement. Prospective investors now see positive momentum. The Chairman’s statement finished with this note:
“The second half has commenced positively, aided by the strong mid-year order book. Organic order intake in the third quarter is well ahead of last year, albeit less buoyant than in Q2 2015. Overall order intake since the beginning of the year is consistent with the Group’s sales budget and your Board remains confident in the ability of the Group to meet market expectations for the full year.”
To tie it all together; the order book and revenue profile of the group is inherently uncertain. These are mostly discretionary purchases with relatively limited recurring revenue. Given that, I don’t think there’s a better yardstick than recent order intake for making revenue assumptions. Historically speaking, the group has been pretty good at making its budgeted order numbers, plus some organic growth.
Based on order intake numbers, and assuming they maintain something like the profile they highlighted in their results announcement, I think the group can bring in ~£56.5m of revenue next year. Blending historic group margins with the addition of Armfield suggests that we can expect margins in the ballpark of 17 – 20%. If you work that through, you get to net profit of something like £8m.
Against the current price of £89m, I think this is a good price. A collection of assets with this quality – good organic growth rates, clear tailwind and exceptional returns on invested capital – is not normally bought for 11x. You are, to some extent, paying to underwrite the risk of poor order intake… but the real people who underwrote that risk were the buyers at £24 a couple of years ago. Bad numbers have a nice way of inflicting market pessimism (what if order intake goes back down again?!), but I think the risks to Judges’ order intake are, at worst, symmetrical to the upside and downside. Management are honest, and the company seems solid.
If you are short-sighted, you ride the wave up to 16x earnings as and when the group’s outlook becomes more rosy again and earnings growth resumes. This is modest upside of 50%.
If you have a longer time time horizon and, crucially, you believe the long-term story that management both have and will continue to create value, I said in May that I thought the group could be worth £40 within 4 years. Assuming they continue to find companies to buy to reinvest their capital, I still think that can be the case. The difference is that the IRR is better now!