Judges Scientific: Two Steps Forward

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.

Armfield

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

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:

JDG order intake

In the group’s press releases, they also make some comment to the underlying data:

“Timpact 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.”

Conclusion

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!

5 Replies to “Judges Scientific: Two Steps Forward”

  1. AVI

    Few questions:

    Given there hasn’t been much downturn in scientific instruments (yet, a bit of a wobble last year but potentially more to come given current economic environment) do you think margins could be elevated – i.e. through-cycle margins on these latest acquisitions might be lower?

    How do you view the IRR from a typical deal if they can buy at 4-6x EBIT?

    What’s your estimate of normalized EV/EBITA or EV/NOPAT? I believe you are looking at leveraged returns (i.e. P/E) with your 11x earnings, right?

    • Lewis

      Hi AVI,

      On the first question; firstly, we should differentiate between margins and returns; not for pedantry’s sake, but just because Armfield was a lower margin acquisition and including it into the mix will pull down margins (without impacting returns) in the next couple of years. So we will structurally have a lower consolidated group margin now. This effect may well continue if execute more acquisitions like Armfield, with a lower asset intensity but higher margins. I haven’t changed my assumption of RoIC on new acquisitions and I am indifferent between 10% op margins @ 2x asset turn or 20% op margins @ x asset turn.

      I think the question you’re really getting at, though, is whether the earnings base of the group might be cyclically overstated by 8 years of strong sales in scientific instruments.

      I don’t think there’s much good data for estimating the strength or otherwise of the end markets to which Judges primarily sells. So I think you need to think about the inputs toward the strength or otherwise of the market and decide based on that. I believe they are predominantly leveraged to:

      – Chinese building of educational institutions (China is maybe 25% of group sales)
      – Overall sizes of governmental budgets (they sell predominantly to higher education institutions)
      – Spending on ‘knowledge’ R&D vs. investment in plant etc.

      I think the first one might be slowing down, but is probably a mega trend. China has a lot of catching up to do and will want to build more world-class universities. I think the second one is probably closer to a cyclical low than a cyclical high, but I acknowledge risks. I think the third one is probably also on a steady upward path.

      Actually, I think the main area of concern for investors should be one tangential to the one you identified. Not ‘what will happen to the general market’, but ‘what will happen to Judges’ slice of that market’? They are very idiosyncratic, with very nichey products, and in my discussions with other investors the question has always been about whether Judges can buy companies and keep up a culture of R&D and product development inside those companies. They typically buy them from a departing scientist/founder, after all, so what’s to say they’re not just buying ‘run-off’ businesses which’ll die out after the current product series? I don’t think this is the case – I think they are careful purchasers, I think they buy when there is a strong second tier management or they can ensure R&D continuity, but that question keeps me up at night more than the general market one does. The market will be lumpy but positive, I feel.

      Re: IRR on typical deals – this completely depends on how aggressive you make the organic growth assumptions. Your levers are your price paid (5x = 20% return on initial investment, unlevered and untaxed) the organic growth assumptions (group has managed high single digits historically, is this sustainable?), and the return on incremental organic growth (I think this is 50%+). Then, obviously, decide how much leverage you’re comfortable attributing – and will you look at this on a deal-by-deal or on a consolidated basis? I said in the post that I think they bought Armfield at something like a 25% incremental return on equity, and I think organic growth will come at a RoE significantly north of that. That gives you an upper or lower bound of IRR. I don’t think Armfield is an atypical deal, and the fact they are reinvest their cashflows at these rates is why I am excited.

      Re: normalised EV/EBITA – I think just under 9x on 2016 numbers, the year which ends in ~380 days. This is assuming no acquisitions. I assume they can make £8m of net profit and £10.5m of EBITA.

  2. AVI

    Thank you for the reply awhile back. Reviewing the stock again and 2 more questions:

    Margins: From 2007-2014, avg EBITA% was 18%. Armfield has lower margins than the consolidated group. 2H’14 EBITA margins were 12.1% & 1H’15 margins were 12.3%. With this data, curious how you make the leap to an assumed 17-20% margin for 2016?

    Intangibles: Good discussion/response to Richard in the last Judges post. I definitely agree on backing out intangibles for customer lists, trademarks, etc. However, note 16 shows 3.52m of the intangibles balances was related to research & development. If JDG didn’t buy these companies, they would have to spend that R&D to develop a the technology to replace those sales/earnings, etc (nevermind this would be difficult). Do you agree? If so, this part of R&D amortization is an on-going expense…

    Return on incremental equity: why do you think it will be 50%+ on organic growth?

    Really appreciate the blog, wish you posted more! 🙂

    • Lewis

      Hi AVI,

      Re: the margins. 2011-2013 group margins were around 21%. Scientifica was earning 23% on acquisition in 2013. I make the assumption that, since the group is a bit bigger now (and there should be operating leverage with the very high gross margins) and given I’ve assumed the order intake will flow through to much recovered revenues in 2016, the ‘core’ group will earn 20% margins. Armfield was stated to make a contribution margin to the main group of 13.6% on acquisition, and given it’s performed well since acquisition I’ve left this at 13.5%. I then blend those margins with my assumptions of segment revenue and get to a consolidated EBIT margin of around 18.5%. The 20% figure I mentioned before was probably a bit aggressive, and should probably be seen as a long term target with operating leverage, and not a near term likelihood unless order intake shoots back up. The difference between the 2H’14 and 1H’15 figures, looking at it from the other angle, basically comes from the fact that you’re adding a significant uptick to a business with very fixed central costs and 60% gross margins.

      Interesting question on the capitalised R&D. I’ve discussed the allocation of R&D resources with management, and how they approach capital allocation in this sense. It should be noted that last year they expensed £1.7MM on R&D, where recognised as such… and I’m not sure it’s completely trivial to come up with a figure for ‘R&D spending’ in a company like Judges. Do you put the entire salaries of certain individuals in the ‘R&D bucket’? Do you say that your engineers are spending half of their time on development, and pretend half of their time is ‘R&D time’? So I would put it this way – I believe Judges are spending the time and money to ensure their product ranges are staying relevant and even growing (as evidenced by mid-high single digit organic growth historically), and that the expensing of all the associated R&D is the most conservative way of doing it. I treat the ‘acquired R&D bucket’ the same way as all other PPA – just an accounting trick. If one wants to treat that as a real intangible asset we should amortise over time, we should treat internally generated R&D spending as an intangible asset, capitalise it ourselves, and then write that off over time, too.

      RoIE – it’s been a while since I’ve done the maths, but you can look at it a few ways. I tried to look at incremental equity kept in the business (excluding acquisitions) on a year-over-year basis, and figure out some proxy for return on organically invested capital like that. You could also look at the returns on capital for the business as a whole excluding goodwill and corporate cash, and use that as a yardstick (I think this is 50% in itself). You could also look at things they acquired, and estimate RoE on those, before the surplus goodwill Judges paid on acquisition (but will never have to pay again). Armfield earned something like £1m in net profit on £3m of net tangible assets when it was acuired. That’s a 33% return on equity, but £2.6m of those £3m net tangible assets was cash. You don’t have to make a big assumption about how much is ‘surplus’ to assume that returns on incremental capital might be 50%+, given operating leverage and so on.

      I’ll see what I can do about posting more this year – it is not easy given my commitments to my employer, but I am optimistic!

      Lewis

  3. Jisare

    Hi Lewis,
    Thanks for your post. I posted one question on your post, only to realize this newer post sitting right here. Please let me write down all my questions here:
    1. Acquisition pipeline and competition. I read another blog (canteatvalue)commenting that deals above 1m pbt will face higher competition. How much run way do you think there is?
    2. Do you get any chance to talk to the actual users of the equipment and get some review?
    3. Did you notice significant pricing policy changes before and after acquisitions?

    Thanks a lot.

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