TerraVest content repository: You can find a great collection of reports, write-ups, podcast mentions, YouTube videos, and presentations on TVK on this page.

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Note that Fairway Research is long TerraVest shares. This is not investment advice. Please do your own due diligence before investing.

Highlights

• Consolidated revenue in Q2 FY2023 increased by 28% including 20% organic revenue growth.

• Growth was driven by buoyant demand from oil & gas customers in both the Processing Equipment and Service segments. Compressed Gas segment also performed well with 32% revenue growth during the quarter. HVAC equipment segment was flat.

• Canadian revenue grew at 2x the U.S. revenue during the quarter driven by demand from Western Canada

• EBITDA margin during Q2 FY2023 increased to 18.2% as compared to 15.4% in Q2 FY2022. This was driven by higher margins in both Processing Equipment and Service segments.

• TerraVest continued its acquisition driven growth strategy by acquiring Secure Energy’s drilling services business for $16 million.

• Based on better than expected results during the last twelve month period, especially the growth witnessed by the Service segment’s and the improved overall EBITDA margins of TerraVest’s business, my estimate of the intrinsic value of the ‘existing business’ of TerraVest is now updated to $35.1 per share from $29.6 in February 2023. The estimate is still does not consider any growth from acquisitions, and takes nominal 2% revenue growth beyond FY2023.

Detailed Quarter and Half-Year Review

Consolidated Revenue

Consolidated revenue for Q2 FY2023 increased by 28% and for H1 FY2023 by 32%. The service and processing equipment segments were the primary contributors to the increase in revenue. In terms of geography, Canadian revenue increased by 37% in Q2 FY2023, and U.S. revenue increased by 18%.

Organic revenue growth during the Q2 FY2023 was 20%, and H1 FY2023 was 8%. The Processing Equipment segment and the Service segment again drove this.

Figure 1: Revenue Breakdown

HVAC Equipment Segment:

Revenue for the HVAC equipment segment was flat quarter-on-quarter and increased by only 2% in H1 FY2023. Organic revenue was down 2% in Q2 FY2023 and increased by 1% in H2 FY2023. The segment witnessed stronger demand for home heating equipment, but it was offset by lower demand for refined fuel tanks.

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Compressed Gas Segment:

Revenue for the Compressed Gas segment increased by 32% in Q2 FY2023 and by 38% in H1 FY2023. However, this increase was primarily attributable to the acquisition of MTC. Organic revenue growth was 2% in Q2 FY2023, and 7% in H2 FY2023. The slight increase in revenue was due to stronger demand for compressed gas storage and distribution equipment.

Processing Equipment Segment:

Revenue for the Processing Equipment segment increased by 24% in Q2 FY2023 and by 22% in H1 FY2023. The entire growth was organic and driven by higher demand for energy processing equipment in Western Canada.

Service Segment:

Revenue for the Service segment increased by 77% in Q2 FY2023 and by 103% in H1 FY2023. However, this increase was primarily attributable to the acquisition of GES in November 2021. Organic revenue growth was 28% in H2 FY2023. The segment benefitted from strong demand from customers due to increased rig utilization and recent asset acquisitions which increased overall capacity.

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Figure 2: Active Rigs in Western Canada

The Processing Equipment and Service segments generally experience higher sales in the first and second quarters as the majority of the drilling in Western Canada occurs during this period. As can be seen from the chart above (Figure 2), drilling activity slows down around April each year.

Reported EBITDA

TerraVest’s consolidated EBITDA increased from $21.2 million in Q2 FY2022 to $32.2 million in Q2 FY2023. EBITDA margin increased from 15.4% in Q2 FY2022 to 18.2% in Q2 FY2023. Consolidated EBITDA increased from $41.5 million in H1 FY2022 to $62.5 million in H1 FY2023. EBITDA margin increased from 15.4% in H1 FY2022 to 17.6% in H1 FY2023. The increase in EBITDA was driven by the following factors:

• Gross margin improvement at the consolidated level from 22% in Q2 FY2022 to 25% in Q2 FY2023, and from 22% in H1 FY2022 to 24% in H1 FY2023. This is despite increased steel commodity prices during Q2 FY2023.

• Increased revenue and margin improvement in the Processing Equipment Segment. The segment’s EBITDA margin doubled from 7% in Q2 FY2022 to 15% in Q2 FY2023, and 5% in H1 FY2022 to 11% in H1 FY2023.

• Increased revenue and margin improvement in the Service segment. The segment’s EBITDA margin increased from 21% in Q2 FY2022 to 28% in Q2 FY2023, and 18% in H1 FY2022 to 27% in H1 FY2023.

Figure 3: EBITDA Breakdown

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Working Capital

The high working capital levels seem to be slowly normalizing. Working capital as of March 2023 was at 30% of revenue, down from the levels of 34% as of September 2022 and 46% as of September 2021.

Acquisitions

On March 1, 2023, TerraVest acquired the assets of Secure Energy (Drilling Services) Inc.(“SES”) for $16 million. SES provides on-site water sourcing, filtration, pumping, storage, and heating services. SES activities and results have been fully integrated into one of TerraVest’s existing subsidiary’s financial results and activities. The acquisition multiple cannot be determined based on the information disclosed by the company.

Normal course issuer bid

On March 15, 2023, TVK announced the renewal of its normal course issuer bid for up to 949,963 shares (10% of public float) before March 2024. There were 17,831,318 shares outstanding as of March 7, 2023. TVK bought back 43,100 common shares in FY2022 (1,233,826 in 2021).

Financial Highlights

Figure 4: Financial Overview

Intrinsic Value of existing TVK (without acquisition value)

In my February 2023 deep dive, I estimated that the intrinsic value of TerraVest’s existing business is $29.6 per share. That estimate was based on highly conservative assumptions.

My estimate of the intrinsic value of the existing business is now updated to $35.1 per share. The increase is driven by the following updates to the discounted cash flow valuation model:

• Revenue estimate for FY2023 now increased to $692 million as compared to $623 million. This was primarily driven by TerraVest revenue performance during the last twelve months which sets revenues at $662 million.

• EBITDA margin estimate for FY2023 now increased to 16% based on TerraVest’s last twelve month EBITDA margin of 16.6%.

• Long-term EBITDA margin expectation has now been increased to 14.5%, as compared to 14% in February deep dive. This change is based on better than expected margin performance of the Processing Equipment segment and the Service segment during H1 FY2023, and the increased weighted on the high margin Service segment in TerraVest’s overall portfolio.

Figure 5: Share Price Vs. Intrinsic Value Estimate

The intrinsic value estimate of $35.1 per share implies an LTM EBITDA multiple of 8.0x as compared to the current traded LTM EBITDA multiple of 6.8x.

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Other updates:

Note on seasonality:

TerraVest’s operating segments are seasonal in nature. The strongest quarters for TerraVest are its first and last quarters. The Processing Equipment and Service segments generally experience higher sales in the first and second quarters as the majority of the drilling in Western Canada occurs during this period. The HVAC Equipment and Compressed Gas Equipment segments generally experience higher revenues during the first and last quarter as demand for residential, commercial, and industrial heating products increases heading into the winter months. The third quarter is typically the weakest across all segments.

TerraVest takes advantage of this seasonality to build inventory levels during non‐peak demand periods, thereby allowing TerraVest to more readily meet increased levels of demand during its regular peak demand periods.

TVK at NGPA Nashville Summit (April 2023):

TVK’s full propane lineup was visible at the National Propane Gas Association (NPGA) summit at Music City Centre, Nashville from April 23-25, 2023. Infant TVK had the biggest exhibition room at the event. In 2022, there were 4,100 people in attendance at this event.

Thanks for reading. Please share any comments and feedback below. You can also find me on Twitter or email me at fairwayresearch@gmail.com.

Thank you for being a subscriber to Fairway Research. Before we get into deep dive #6 on Sleep Country Canada, I want to share that Fairway Research has gone soft-paid. It means that all content is still free but if you want to support my work, you can do so by buying a monthly or annual subscription. It is entirely optional and up to you. These deep dives are fun but also a lot of work and I hope you see value in them. I appreciate your support and readership.

As always you can download this report in a PDF for a much better reading experience. I suggest reading it on a tablet or desktop. Now let’s get into Sleep Country.

Fairway Research Sleep Country Deep Dive April 2023

2.05MB ∙ PDF file

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Please note that this report is not investment advice. Fairway Research may or may not hold positions in the stock discussed. Please do your own due diligence before investing.

Executive Summary:

Sleep Country is Canada’s largest specialty mattress retailer with an estimated market share of 37% as of 2022. The company has a coast-to-coast retail network of 289 stores supported by 20 warehouses.

In addition to being the leading brick-and-mortar retailer in Canada, Sleep Country also owns e-commerce mattress and accessories brands such as Endy (bed-in-a-box), Hush (weighted blankets), and Silk & Snow (bed-in-a-box). Most recently, Sleep Country acquired the Canadian operations of the U.S. DTC mattress brand, Casper.

In 2022, Sleep Country had revenue of $929 million, out of which 80% came from retail stores and 20% from e-commerce. In terms of product revenue, 76% of Sleep Country’s revenue comes from mattresses and the remainder from the sale of accessories such as pillows, duvets, etc.

While the mattress industry has been in turmoil, Sleep Country has delivered strong financial performance along with an increasing market share in Canada from 23% in 2015 to 37% in 2022. This was a result of consistent investment in the brand, the fall of Sears, which was a major competitor, and taking share from smaller independent mattress retailers.

Mattress firms performed exceptionally well during 2020-2022. This was primarily driven by pandemic stimulus spending and the increased focus of households on home-related expenses as people spent more time at home. As interest rates started increasing in 2022, Sleep Country’s same-store sales quickly turned negative.

I believe that the market is currently pricing a severe recession for Sleep Country. It currently trades at an EV / EBITDA multiple of 5x, which is the lowest since its IPO in 2015. In addition to acquiring companies at lower multiples, the management has been smart to use the current valuation levels to buy back over $50 million worth of stock in 2022.

Using a discounted cash flow model and very conservative assumptions, I estimate that Sleep Country’s intrinsic value per share is $30, representing a 30% upside from the current levels.

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A. Introduction

In this report, we take a deep dive into Sleep Country Canada Holdings Inc. (TSX: ZZZ) (“Sleep Country”). Sleep Country is Canada’s largest specialty mattress retailer with an estimated market share of 37% as of 2022.

For my readers, I want the core takeaways from this report to be a good understanding of Sleep Country’s business and how the market seems to be overly pessimistic about its prospects.

The main sections of the report are:

Section B: discusses the pre-IPO and post-IPO business history of Sleep Country.

Section D: discusses the high-level structure of the mattress industry in Canada.

Section E: discusses the business of Sleep Country by breaking it down into 2 main segments, brick-and-mortar, and e-commerce. This section also goes into Sleep Country’s brand.

Section F: discussed how Sleep Country has managed to increase its market share despite other players struggling.

Section G: tries to understand the impact of a recession on the mattress industry and the implications for Sleep Country.

Section H: discussed the historical financial performance of Sleep Country including same-store sales growth.

Section J: uses a discounted cash flow methodology to estimate the intrinsic value of Sleep Country.

Figures in the report are in Canadian dollars unless otherwise noted.

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B. Business History

i. Pre-IPO

A gap in the market

Sleep Country was founded in 1994 by Christine Magee, Stephen K. Gunn, and Gordon Lownds with four stores in Vancouver. Gunn and Lownds were partners in a boutique investment banking firm involved in the leveraged buyout of mattress manufacturer Simmons Canada. Through their involvement in that transaction, they realized that distribution channels for mattresses to the customers were not effective. Gunn and Lownds had known Magee in her days as a banker at National Bank. Gunn and Lownds brought Magee on board, and together the three launched the first four Sleep Country locations in Canada. By 1996, it had expanded to Toronto with 19 new stores; by 2001 it had 72 stores. In 2003, Sleep Country converted to an income trust and raised $120 million in its first IPO.

Quebec Acquisition

In 2006, Sleep Country acquired 5 stores in Dormez-Vous Sleep Centres, a Montreal-based mattress retailer which was started by Steward Schaefer, who came over to Sleep Country with the acquisition and took over as the CEO in 2022. Schaefer admitted that his strategy early on was to imitate what Sleep Country was doing in the market and bring it to the Quebec market.

The American misadventure

In 2006, Sleep Country also acquired the 32 stores of Sleep America LLC. However, this turned out to be a misstep as they purchased Sleep America at the peak right before the housing crash. Sleep Country grew much quicker in Canada as the competition was less intense as compared to the U.S. The company later sold Sleep America in 2015 for half of what it had paid nine years earlier.

Buyout by private equity

In 2008, the Sleep Country Income Trust was acquired by a group of investors led by Birch Hill Equity Partners and the company management for $356 million.

Back to the markets

After staying away from the markets for seven years, Sleep Country completed its IPO on the TSX by raising $300 million and began trading under the ticker symbol (ZZZ).

ii. Post-IPO

In 2018, Sleep Country acquired Endy, a Canadian bed-in-a-box online retailer. In 2021, it acquired Hush Blankets, a DTC e-commerce sleep retailer. In early 2023 it acquired Silk and Snow, another DTC sleep retailer. Most recently in April 2023, Sleep Country announced that it is acquiring the Canadian operations of the U.S. DTC mattress brand, Casper.

As of December 31, 2022, Sleep Country had 289 company-owned stores in Canada under the Sleep Country and Dormez-vous brands. The company also has 17 Sleep Country Express / Dormez-vous Express stores in partnership with Walmart Canada. Sleep Country currently holds an estimated 37% market share in Canadian mattress retail.

For the year ended December 31, 2022, Sleep Country had revenues of $929 million. The company has around 1,600 full-time associates on its payroll.

C. Stock Performance

After listing at close to $15 per share in 2015, Sleep Country’s share rose to $41 in June 2017, before sliding downwards and staying close to $20 during the whole of 2019. In March 2020, Sleep Country’s share fell to $9.3 per share driven by pandemic store closures, before slowly recovering to all-time high levels of $40-$41 per share in November 2021. Sleep Country also delivered one of its strongest financial performances in 2021. Throughout 2022, Sleep Country’s share steadily corrected on recession fears, falling consumer confidence, rising interest rates, and a decrease in same-store sales. As of April 19, 2023, Sleep Country’s share trades at $23.57, with a 52-week high of $29.91 and a 52-week low of $19.66.

Figure 1: Historical Stock Performance

D. Mattress Industry Landscape

Before understanding Sleep Country’s business, it is important to understand how the mattress industry works.

Figure 2: Canadian Mattress Industry Landscape

Mattress Manufacturers

Tempur Sealy and Serta Simmons are amongst the largest mattress manufacturers in the world. Purple Innovations is another up-and-coming mattress brand with more focus on the DTC space.

Tempur Sealy had 2022 revenues of close to US$5 billion and a 38% market share in the U.S. 77% of Tempur Sealy's revenue came from the wholesale channel, i.e., via mattress retailers such as the Mattress Firm, Walmart, and Costco. Only ~6% of Tempur Sealy’s revenue is estimated to come from Canada.

Serta Simmons is estimated to have $2.2 billion in revenue, however, it currently going through bankruptcy proceedings in the U.S.

Purple Innovations had revenue of $0.6 billion in 2022 with 43% revenue coming from the wholesale channel. However, Purple had minimal revenue outside the U.S. Purple has an exclusive partnership with Sleep Country for the Canadian geography.

Mattress manufacturing firms often have significant customer concentration. In 2022, 15% of Purple and Tempur Sealy’s revenues came from a single wholesale customer.

Mattress Distribution

The Canadian mattress retail industry is estimated to be $2.5 billion in size.

Omni Channel

Omnichannel distribution means that the retailer has a presence in both brick and mortar as well as online.

In Canada Sleep Country is the largest omnichannel mattress retailer with an estimated market share between 35% to 40%. In April 2023, Sleep Country entered into an agreement to acquire the Canadian operations of Casper, a leading U.S. DTC mattress brand that entered the Canadian market in 2018. LGL Group which owns the Brick and Leon’s furniture stores has the second largest market share in Canada after Sleep Country.

Other major omnichannel mattress retailers include Ashley, IKEA, and Quebec-focused BMTC Group which runs the Brault & Martineau store and EconoMax stores. Costco and Walmart Canada also sell mattresses both through their marketplace websites and stores.

Direct to Customer / Online / Bed-in-a-box

The bed-in-a-box industry was touted as a disruptor of brick and mortar dominated mattress industry. In the U.S., online mattress retail accounts for $6 billion out of $18 billion in industry revenue. Amazon is the largest DTC mattress retailer with estimated revenues close to $2 billion, followed by Resident at $600 million and others such as Avocado Green brands, Saatva, and Wayfair.

In Canada, Sleep Country-owned, Endy, which it acquired in 2018, is the largest bed-in-a-box brand. If we consider U.S. DTC sales as an indication, Amazon.ca is likely the largest DTC mattress seller in Canada, followed by Wayfair. Goodmorning.com and Polysleep are other DTC mattress retailers in Canada.

Mattress purchase decision

A mattress is a big-ticket infrequent purchase, and it is difficult to compare models and brands. As per UBS Evidence Lab, a U.S. survey of 2,500 consumers indicated that 43% of participants bought a mattress online, while 42% purchased a mattress in a brick-and-mortar store. Another 15% was purchased through both channels. Since it is such a personal product it is important to test the product before buying it. Customers often require the help of sales associates, to help select the right model.

An estimated 75% of mattress sales are for replacement. A typical mattress has a life of between 7 to 10 years. However, this figure has been shrinking over time. The time consumers have kept a mattress before replacing decreased from 10.3 years in 2007 to 8.9 years in 2016.

Mattresses are also among the first purchases to be delayed in case the money is tight making them highly discretionary products. But since a mattress is a necessity and not a fashion item, the purchase is generally delayed rather than lost. Consumer preferences have also been evolving towards premium quality and larger mattresses. The mattress industry is also able to pass on any increases in inflation to the customers. (See Figure 3)

Figure 3: Increase in mattress average selling price

Else than replacement, other triggers for mattress purchase include buying a new house, starting a new family, getting divorced, or going to university. Another interesting statistic is that 90% of purchasing decisions around home goods such as mattresses are made by women.

Players in the mattress retailing industry compete on various factors such as store locations, service and delivery experience, price, product selection, and brand name recognition. It is no surprise that the most cited factor in the mattress purchase decision, for both outlets selected as well as the brand purchased, is price. For retailers, other determining factors include the selection of products, location, and previous experience.

E. Understanding Sleep Country’s Business

Sleep Country is the largest brick-and-mortar retailer of mattresses in Canada. Its business can be essentially divided into two parts. The brick-and-mortar stores and the e-commerce business. Figure 4 below lays out the Sleep Country House of Brands platform.

Figure 4: The Sleep Country House of Brands Platform

1. Brick-and-Mortar Stores

Sleep Country has a coast-to-coast network of 289 stores under the Sleep Country and Dormez-vous (Quebec only) brands. 12 of these stores are located in malls. It also has 17 Sleep Country Express / Dormez-vous Express stores in partnership with Walmart Canada. During 2022, Sleep Country’s retail stores generated $747 million in revenue contributing 80% of its total revenue. The retail stores primarily sell mattresses and accessories such as pillows, duvets, etc. At a consolidated level Sleep Country gets 76% of its revenue from mattress sales and the remaining comes from accessories. This translates to an average revenue per store of $2.6 million and revenue per sq. ft. of $531. This compares well to the revenue per store of the Mattress Firm, the largest mattress retailer in the U.S., which had a revenue per store of $2.3 million in 2021.

Sleep Country’s stores are generally about 5,000 sq. ft. and are located close to residential areas. The store network is curial to the mattress business because most customers still finalize purchase decisions in the store after trying the mattress. They might shortlist and compare products online; however, the final decision is generally made in-store.

Sleep Country’s retail network is supported by 20 warehouses across Canada which have over 1 million sq. ft. of warehouse space.

Figure 5: Sleep Country’s Coast-to-Coast Retail Network

Store / Unit Economics

As mentioned above, a typical Sleep Country store is about 5,000 sq. ft and on average has $2.6 million in revenue. This translates to revenue per square foot of $531 per year. A new store costs about $460K and generates revenue of $1.8 million in the first year of operations. The payback period is generally around 10 months. Of course, there can be some cannibalization of sales from existing Sleep Country stores in case of new stores in existing markets. Even if we assume that a store pays back itself in 12 months, it represents a return on incremental capital invested of 100%, which is very impressive.

Figure 6: Sleep Country Store Level Revenue

Figure 7: Sleep Country New Store Economics

The Brand

The common theme among retailers is the need to maintain a brand and the consistent advertising spend that is required. Sleep Country is already one of the most recognized brands in Canada. In the ’90s, Sleep Country filled the airwaves across TV and radio with its brief memorable jingle, which was rated as Canada’s catchiest advertising melody - “Sleep Country Canada / Why buy a mattress anywhere else?”.

From its early days Sleep Country preferred spending on TV and radio ads as compared to print ads preferred by the competition. Another uniqueness about Sleep Country was that co-founder Christine Magee remained the face and voice of the brand since its inception. A strategic move given the fact that 90% of purchase decisions for household products are made by women. In 2018, Sleep Country disclosed that it is able to convert 60% of its shoppers into buyers. An impressive percentage if true.

Figure 8: Co-founder Christine Magee has been the face of Sleep Country since its inception (1999 commercial).

Figure 9: Sleep Country’s Media and Advertising Spend

The company is often among the top radio advertisers in local markets. It spends close to 7%-8% of its revenue on media and advertising. Since Sleep Country is the only mattress retailer in Canada with a national scale, it also gets efficiencies in national advertising where it buys advertisements from media companies in bulk.

It is also an industry tradition for mattress manufacturers to help push local marketing where the retailer’s brand is advertised alongside. Below are some examples from Simba and Kingsdown.

Mattress delivery is the key to customer experience.

One of the key features of Sleep Country’s buying experience is delivery. Sleep Country’s deliveries are generally scheduled within a 3-hour window. Delivery people wear shoe covers to avoid spoiling the floors of the customer’s houses. This is important in Canada where we have snow covered environment for almost 5-6 months of the year. The delivery personnel can also take the previous mattress for recycling or donation, along with any packaging materials with themselves instead of leaving them at the customer’s house. This leaves the customers with a great last impression. Stores such as IKEA do not provide such services with their delivery. Small independent stores also can’t provide such services due to limited resources. Stores such as Ashley provide this service for an extra charge. Note that disposing of an old mattress generally requires the customer to hire a truck and take it to the community recycling center. So, Sleep Country’s delivery service elevated a real pain point for the customer. In 2022, Sleep Country spent 0.3% of revenue ($3 million) on recycling and donation of old mattresses.

A Saturated Brick and Mortar Market

Because the Canadian market is saturated, the growth of brick-and-mortar stores will likely be limited. In 2018, the management of Sleep Country estimated that it can have 1 store for every 100,000 Canadians, which considering the latest population statics as of 2023 would translate to about 390 stores. That is another 100 stores from the current figure of 289 stores. Of course, there are several factors that can have an impact on this estimate. The management has also identified 80 to 100 Walmart Canada stores for Sleep Country Express store-in-store concept. Competition from Leons and the Brick, IKEA, and especially the DTC segment led by Amazon and Wayfair can have a great impact on the market’s appetite for new Sleep Country stores. Since 2020, the number of new stores opened per year has considerably slowed down. The pandemic played a significant role in the slowdown.

Sleep Country has recently announced its intentions of revamping its current stores. This revamp is expected to give more square footage to bedding accessories, which have 10% higher gross margins as compared to mattresses.

Figure 10: Net New Stores

2. E-Commerce

Sleep Country launched its e-commerce division in 2017. Over the next 6 years, through a mix of acquisitions and organic growth, Sleep Country’s e-commerce revenues have grown to $182 million. Its two main acquisitions in the e-commerce space were the 2018 acquisition of Endy and the 2021 acquisition of the DTC brand Hush.

In 2018, Sleep Country acquired Endy which is the largest DTC bed-in-a-box player in Canada. Prior to Endy acquisitions, Sleep Country had launched its own bed-in-a-box brand “Bloom”.

In 2020, Sleep Country started disclosing its e-commerce revenue. In 2020, E-commerce revenue was $162 million representing 21% of total revenue. 2021 witnessed an exceptional growth of 33% over 2020, increasing to 24% of revenue. However, as the pandemic resided in 2022 and e-commerce sales decreased to $182 million, representing about 20% of total revenue. Below we discuss the acquisitions which have driven this e-commerce push for Sleep Country.

Figure 11: Sleep Country E-Commerce Revenue

i. Endy Acquisition (2018)

In 2018, Sleep Country acquired Endy for $89 million. The transaction included the payment of $64 million in cash and an earn-out of up to $25 million based on profitability targets for 2020. Endy was growing rapidly with 2018 revenue having grown over 150%. The cash component of the consideration was valued at 12x Endy’s LTM EBITDA. At the time of the acquisition Sleep Country’s own multiple was ~9x EBITDA. The acquisition was primarily financed through debt. Endy operates as a separate entity within the Sleep Country corporate structure. Through the acquisition, Sleep Country wanted to increase its participation in DTC segment growth and enhance its exposure to the online channel. Endy is currently the leading bed-in-a-box brand in Canada and is estimated to have revenue of $86 million in 2022.

ii. Hush Acquisition (2021)

In 2021, Sleep Country acquired a 52% interest in Hush which was started in 2017. 90% of Hush’s revenue came from weighted blankets. It paid $25 million for the majority stake at 9x Hush LTM EBITDA. At the time of the acquisition, Sleep Country’s own multiple was also close to 9x EBITDA. Sleep Country also agreed to acquire the remaining 48% by March 2023 at a valuation of 7x LTM EBITDA. The acquisition was financed through debt. Hush continues to operate as a separate business within Sleep Country with backend support in form of finance, warehousing, and distribution.

iii. Silk & Snow Acquisition (2023)

In early 2023, Sleep Country acquired Silk and Snow for an upfront consideration of $24 million. The consideration represented 5.6x LTM EBITDA. This is close to Sleep Country’s own traded multiple in 2023. Sleep Country agreed to a contingent consideration of an additional $19.5 million to be paid in 2026 based on Silk and Snow’s performance during 2023-2025. The transaction was financed through debt and cash on hand. Silk & Snow had revenue of $35 million in 2022, of which 94% came from mattresses.

iv. Casper Acquisition (2023)

In April 2023 Sleep Country acquired the Canadian operations of Casper Sleep Inc. for $20.6 million. Casper is one of the U.S. mattress industry’s most recognized brands. Casper’s Canadian operations had LTM revenue of ~$40 million with 6 retail stores, Casper.ca website, and partnerships with Costco, Indigo, The Bay, and Loblaws marketplace. In addition, Sleep Country invested US$20.0M in Casper via a 5-year convertible note, which will have the option to convert into an ~5% common equity stake in Casper.

Figure 12: EV / EBITDA multiples paid for acquisitions (based on cash consideration only, Ex. contingent Consideration)

Summing up Sleep Country’s acquisition strategy

Sleep Country has made smart acquisitions during the last 5 years. Between 2018 and 2022, Sleep Country spent $104 million on acquisitions. Year to date, it has already paid $44 million for 2 new acquisitions (Casper and Silk & Snow).

Whether it is Endy, which has now become the leading DTC mattress player in Canada, or the struggling Casper exiting the Canadian retail space, Sleep Country has been opportunistic when it comes to buying companies. In line with the decrease in its own multiple in the market, it has paid reasonable EV / EBITDA multiples for acquisitions. The higher multiple in Endy might be justified by the astronomical growth it was witnessing around the acquisition.

Sleep Country also seems to be getting minimal competition for deals. Leon’s, the second largest mattress retailer in Canada, has not made any acquisition since it acquired the Brick retail chain in 2013 for close to $700 million.

All acquisitions have generally had an element of contingent consideration which is a good risk mitigation strategy. Further, all acquisitions have been funded through cash on hand and debt, with no new equity raised for any acquisitions.

I will conclude this section on Sleep Country’s business with this quote from management which neatly sums up the house-of-brands strategy:

F. Dealing with Competition

Mattresses are a tough business.

The mattress industry is tough. Mattress retail is tougher. The Mattress firm, which is the largest mattress-focused retailer in the U.S. filed for bankruptcy in 2018 and had to close 700 stores. Competition from bed-in-a-box online retailers and a financial scandal at the parent company level were blamed for the Mattress Firm’s problems. Most recently it paused its plans to go public again citing volatility in the IPO market.

E-commerce in the mattress space isn’t easy either. Between 2011 and 2018 over 100 bed-in-a-box websites were launched. Casper, a unicorn bed-in-a-box startup launched in 2014, was the leader of the pack. In February 2020, Casper went for an IPO right before the global pandemic shut down the economy. Bad timing.

According to its latest annual report, Casper reported a net loss of nearly $90 million on revenues of $497 million in 2020. In November 2021, private equity firm Durational Capital Management bought Casper. In April 2023, Casper sold its Canadian operations to Sleep Country.

Another e-commerce bed-in-a-box retailer, Purple Innovations, has faced a similar fate. The company’s stock is down from a high of US$40 in early 2021 to US$2.7 in April 2023. The company has a net loss of US$90 million in 2022.

Sleep Country’s Market Share

While all this has been happening in the background, Sleep Country has been growing from strength to strength. It has managed to consistently increase its market share each year. In 2015, at the time of its IPO, Sleep Country’s market share was estimated at 23%. By 2022, Sleep Country estimated that its market share had increased to somewhere between 35 to 40%. While Canada is a much smaller market as compared to the U.S., the Mattress Firm, only holds a 20% market share in the U.S.

Figure 13: Sleep Country’s Market Share in Canadian Mattress Industry

But how has Sleep Country been able to consistently win market share?

One big push - the fall of Sears Canada

It got one big push when the second largest mattress retailer in Canada, Sears Canada, went out of business in 2017 - 2018. It was estimated that Sears held 15% of the mattress retail market share in Canada. This was eventually picked up by the remaining players such as Sleep Country. Specialty retailers such as Sleep Country in the mattress category, Leon’s and Brick in the furniture category, Future Shop in electronics, and Toys “R” Us are often cited as one of the reasons for Sears Canada going out of business.

Figure 14: Canadian Mattress Retail Market Share (Excluding Quebec) (2015)

Winning Market Share from Independent Stores

Sleep Country has also won market share from smaller independent mattress retailers, who do not have the resources to maintain a strong online presence. These stores especially suffered during the pandemic period when they were shut down for extended periods of time without any online infrastructure.

G. How bad can a recession be?

One of the main criticisms of retailers in the current environment is that they were over-earning during covid. The stimulus cheques flushed consumers with cash, resulting in an unprecedented increase in consumer spending. Especially for home furnishing products since people were spending more time at home. However, as interest rates increased, consumer sentiment quickly changed.

Sleep Country experienced negative same-store sales growth of 11% in Q3 and Q4 of 2022. This was in line with mattress manufacturer, Tempur Sealy which also saw revenue declines of 6% and 13% in Q3 and Q4 of 2022. So, it becomes important to gauge how bad a recessionary environment can get for Sleep Country.

Mattress Industry typically bounces back from recessions

Figure 15: US Mattress and Foundation Wholesale Market Revenue

If we consider the period during the 2008-2009 financial crisis, the U.S. mattress revenue decreased from $6.9 billion in 2007 to $5.7 billion in 2009, a decrease of 17.5%. It took the industry another 4 years to reach the revenue levels of $6.9-$7.0 billion. During the 2000-2001 tech bubble, the mattress industry sales were essentially flat for one year. Also, prior to 2020, the mattress industry had been flat for almost 3 years between 2017 and 2019. However, none of the other recessionary periods had a material impact on Sleep Country’s revenue.

How did Sleep Country do during the great financial crisis?

During the 2007 to 2008 period, Sleep Country managed to increase sales by opening more new stores. But even with the increase in stores, its same-store sales growth in Canada was an impressive 4.5% during Q2 2008. As per Statistics Canada, sales at big mattress retailers slid 12 % in the first quarter of 2009.

If we consider the performance of Sleep Country’s US peer, the Mattress Firm during 2008 - 2009, it witnessed a same-store sales decrease of 24% in 2008 and another 4% decrease in 2009.

Figure 16: Sleep Country’s Results for the 6 months ended June 2008

While as investors we may say that 2023 is not comparable to 2007-2008, these are still good datapoint to help us access the downside risk. Another argument is that the current decrease in same-store sales is already higher than the decrease witnessed in 2008, notching up the risk of 2023 being worse than 2008.

Another data point is the expected growth rate as per the industry body. The International Sleep Products Association (ISPA) is predicting that the mattress industry in the U.S. will remain flat in 2023 and increase by 5.5% in 2024.

Another indication is the consensus analyst revenue estimates for various mattress manufacturers and retailers. Most consensus estimates currently project low or slightly negative growth in 2023 and then slightly higher growth in 2024 and 2025.

Figure 17: Consensus Revenue Growth Estimates as per Koyfin

We will take the above data points and incorporate them in our DCF assumptions in Section J.

H. Sleep Country’s Historical Financial Performance

Figure 18: Sleep Country Historical Financial Performance

1. Revenue growth

Sleep Country’s revenue grew from $587 million in 2017 to $929 million in 2022 at a CAGR of 9.6%. In 2022, 76% of revenue came from mattress sales and 24% came from accessories. During the previous 5 years, mattress revenue grew at a CAGR of 8% and accessories grew at 14%. Out of the total revenue of $929 million in 2022, 20% came from e-commerce and 80% was in-store sales.

Drivers of revenue growth:

Net new stores: From 2018 to 2022 Sleep Country opened 46 new stores and closed 4 stores. At the same time, it also relocated or renovated 90 stores. Sleep Country also opened 17 express stores in partnership with Walmart Canada during 2021-2022. Its average revenue per store grew from $2.1 million in 2020 to $2.6 million in 2022. At the same time, revenue per square foot of retail space was $531 in 2022, up from $437 in 2020 (note that retail stores were closed for part of 2020 due to covid restrictions).

Same-store sales growth: Sleep Country witnessed exceptional same-store sales growth during the second half of 2020 and the entire of 2021. But as interest rates started rising in 2022, same-store sales went negative. Prior to the pandemic, Sleep Country’s same-store sales growth rates had decreased substantially from the levels witnessed in 2016 and 2017 but had only been negative in 3 quarters.

Figure 19: Sleep Country’s Same Store Sales Growth %

E-commerce: Sleep Country witnessed mixed e-commerce revenue growth between 2020-2022. E-commerce revenue increased by 33% in 2021 and then decreased by 16% in 2022.

Sleep Country’s revenue generally has slight seasonality with higher sales in the third and fourth quarters.

2. Expenses

i. Cost of goods sold (COGS)

Sleep Country’s COGS before 2020 remained in the tight range between 69% to 71% of revenue. With exceptional revenue growth during the pandemic, Sleep Country’s COGS as a percentage of revenue has decreased to 63% in 2022. As per management the increase in gross profit during 2021 and 2022 was driven by higher average selling prices. Product costs improved from 46% of revenue in 2017 to 42% in 2022. Being the only national mattress retailer in Canada, Sleep Country must enjoy bargaining power against suppliers such as Tempur-Sealy and Serta Simmons. Salaries and wages also improved from 15% of revenue in 2017 to 13% in 2022.

Figure 20: Sleep Country COGS Breakup

ii. Operating Expenses

Sleep Country’s main operating expenses include media and advertising and salaries and wages. Media and Advertising have steadily increased from 5% of revenue in 2017 to 8% of revenue in 2022. I think that since Sleep Country was earning higher margins during 2020-2022 it invested more in its brand and as a result increased its market share. I also believe that these expenses are discretionary and can be reduced in years with challenging growth. The second major expense is cash leases which come to about 5% of revenue in 2022. Note that I make a separate adjustment for lease payment from EBITDA since it is a cash expense.

Figure 21: Sleep Country Operating Expense Breakdown

3. EBITDA

Adjusted for cash leases, Sleep Country’s EBITDA margin over the last 5 years has ranged between 15% (2019) and 18% (2022). The increase was primarily driven by an increase in gross margin and offset by the increase in media spending discussed above. I believe the increase in margin during 2022 will likely see a reversal of around 1% to 2% with long-term margins being in the range of 16%.

4. Working Capital and Capital Expenditures

Working Capital

Sleep Country has maintained a negative working capital during the last 5 years. This is primarily because Sleep Country’s stores only have a few mattresses in inventory, mostly for showrooming. Sleep Country orders its inventory on a just-in-time basis once the customer has placed the order with them. Payment to suppliers generally goes out after 30 days. Over time, Sleep Country has been extending the payment period to suppliers from 46 days in 2017 to 66 days in 2022.

Figure 22: Sleep Country Working Capital Cycle (as of 2015)

However, Sleep Country sells accessories on a cash-and-carry model. This means that they need to keep more inventory in the stores as revenue from accessories increases over time. This has resulted in a bump up in inventory days from 34 days in 2017 to 61 days in 2022.

Capital Expenditure

Sleep Country’s capital expenditure over the last 5 years has averaged 3% of revenue. Out of this, about 1% is expected to be maintenance capex expenditure and 2% is growth capital expenditure.

Figure 23: Sleep Country Capital Expenditure (2008 to 2015)

5. Return on Invested Capital

Over the last 5 years, Sleep Country’s return on invested capital has averaged 17% post-tax and 22.6% pre-tax. I calculate the return on invested capital using the below formula:

ROIC = NOPAT / Average. Invested Capital

NOPAT = (EBIT – Interest on leases) * (1- tax)

Invested Capital = PP&E + Intangible Assets and Goodwill + Working Capital – ROU assets

All of Sleep Country’s stores are on leases. Accordingly, I consider rent as a cash expense instead of dividing it up between depreciation and interest as per IFRS-16. For the computation of EBIT, I subtract interest on leases so that the entire cash rent expense is reflected in the EBIT. I also don’t consider ROU assets as part of invested capital in order to make an apples-to-apples comparison. I also add back one-time items such as ERP implementation costs and acquisition-related costs to EBIT. However, share-based compensation is not added back.

Figure 24: Sleep Country Return on Invested Capital

I. Management

Steward Schaefer (age 57) took over as the CEO of Sleep Country in 2022. Before that, Mr. Schaefer served as the Chief Business Development Officer. He took over the reins from Dave Friesema, who left the business after seven years (2015 to 2021) as the CEO to retire.

Mr. Schaefer, a former commodities trader, has been working in sleep retail for the best part of three decades. He founded sleep retailer Dormez-vous in 1994, growing the business to a household name in Quebec with 5 stores, before being acquired by Sleep Country in 2006. Before that, he co-founded Heritage Classic Beds, a manufacturer, and distributor of iron and brass beds. Mr. Schaefer joined Sleep Country in 2006 as President of Dormez-vous and in 2014 he assumed the role of Chief Business Development Officer. In his role, he led the Company’s growth platforms and oversaw strategic partnerships and M&A opportunities.

Mr. Schaefer currently holds close to 1.8% of the total share outstanding of Sleep Country on a fully diluted basis.

Figure 25: Executive Compensation of Sleep Country

Incentive Plans

Sleep Country’s short-term incentive plans are primarily based on EBITDA performance targets and its long-term incentive plans are based on basic EPS (75% weighting) and revenue growth (25% weighting).

Corporate Culture

Based on Indeed, Sleep Country Canada has the best rating among its competitors in Canada.

Capital Allocation

Over the last 5 years, Sleep Country’s capital allocation has been fairly balanced across various uses of cash flows. The company has not raised any outside equity and financial debt has remained at about the same level as in 2017. The company has invested $121 million in capital expenditure on maintenance as well as opening 42 net new stores and renovating and relocating another 90. It also spent $104 million on two big acquisitions of Endy in 2018 and Hush in 2021.

In addition to regular dividends, the company also bought back $58 million worth of stock in 2022. The management rationale for the buyback was that the company was trading at its lowest-ever multiples in the market. I believe the management of Sleep Country has maintained a very balanced approach to capital allocation. Instead of opening more and more stores to bump up revenue in 2022, the company focused on a significantly large buyback, clearly indicating they think that the company is undervalued. The management has further intentions to carry out buybacks in 2023.

Figure 26: Sleep Country 5-Year Capital Allocation Summary

J. Valuation: A recession is already priced in

Current Valuation

For the reasons discussed above, Sleep Country currently trades at the lowest EV / EBITDA multiple since its IPO in 2015. The market seems to be very pessimistic about mattress companies. The buoyancy seen during the pandemic has completely faded and a major recession is fully priced it. The concerns are legitimate. However, is the market overly pessimistic about Sleep Country’s prospects?

Figure 27: Sleep Country EV / EBITDA

Intrinsic Value Estimate

To compute the intrinsic value of Sleep Country I use a discounted cash flow model based on very conservative assumptions. I believe that even using very conservative assumptions the intrinsic value of Sleep Country is around $30 per share as compared to the current levels of $23 per share, indicating a 30% upside.

Key Assumptions:

Revenue: I assume that Sleep Country’s 2023 revenue will decrease by 10% to $836 million and then stay flat in 2024. Note that this is a highly conservative assumption as in early 2023 Sleep Country acquired Silk & Snow and Casper’s Canadian operations. Together these two acquisitions should contribute about $70-$80 million in additional revenue to Sleep Country. Post 2024, I assume Sleep Country's revenue will grow only at 3% each year. I assume that Sleep Country does not open any new stores. The assumption of a decrease in revenue is also in line with the decrease in revenue witnessed in the mattress industry during the 2007-2009 financial crisis which we discussed earlier in the report.

Further, given Sleep Country’s close to 40% market share as the only national bedding retailer, dominant position in the bed-in-a-box category in Canada, opportunistic acquisitions of DTC brands and competitors (such as Casper) exiting the Canadian retail space, these revenue assumptions are very reasonable.

Note that my assumption is highly conservative in comparison to consensus analyst estimates which indicate that revenue is projected to grow by 1% in 2023 and 4% in 2024. To illustrate further, my revenue estimate for 2027 is below the consensus revenue estimate for 2024.

Figure 28: Sleep Country Revenue Consensus Revenue Projections as per Koyfin

EBITDA: I assume Sleep Country’s EBITDA margin will decrease to 16% in 2024 and stay at that figure. Note that this is lower than the 16.9% and 17.5% EBITDA margins witnessed in 2021 and 2022.

Maintenance Capex: Sleep Country’s long-term average maintenance capex is around 1% of revenue. However, I conservatively assume 2% of revenue as maintenance capital expenditure.

Discount rate and LTGR: I assume a 10% discount rate and a 2% long-term growth rate.

Terminal value: My terminal value estimate based on a 10% discount rate and a 2% LTGR implied an exit EBITDA multiple of 8.3x in comparison to the current traded EBITDA multiple of 5x. So, there is an implied multiple expansion factored into the valuation.

Figure 29: Discounted Cash Flow

Figure 30: Sensitivity Analysis on Discount Rate and Long-term growth Rate (Intrinsic Value Per Share)

K. Risks

Low management ownership: Schaefer owns less than 2% of the company. However, it is important to note that he has been in the mattress space for almost 30 years now. Not only does he have the experience of starting his own mattress business, but he has also been part of Sleep Country's senior executive team since 2014. His incentive plan is focused on EBITDA, EPS, and revenue targets. This lowers the risk to an extent.

A longer road to recovery in consumer sentiment: Interest rates and inflation might take a while to come down to a more reasonable level.

Multiple rerating from 5x EBITDA to 8x EBITDA might take longer than expected or might not happen at all.

A.             Conclusion

Sleep Country dominates the Canadian mattress retail space with a 37% market share, a national brick-and-mortar presence, and a well-known Canadian brand.

It also has a significant presence in the e-commerce DTC space with brands such as Endy, Hush, and now Casper.

The mattress industry is resilient and typically bounces back from recessionary periods within a few years. Industry association and consensus estimates are projecting flat sales in 2023 with higher growth coming in 2024.

The company is currently trading at a historically low EV / EBITDA multiple. The market has fully priced in a recession. The company’s management took this opportunity to buy back $57 million worth of stock in 2022.

My discounted cash flow model using conservative assumptions indicates that Sleep Country’s intrinsic value should be at least $30 per share. This represents a 30% upside from the current share price of Sleep Country.

Feel free to please share your suggestions, comments, or criticisms below.

Update May 9, 2023:

On May 9, 2023, the Mattress Firm, the largest mattress retailer in the U.S., was acquired by Tempur Sealy, the largest manufacturer of mattresses. The transaction represented a multiple of 9.3x EV/ EBITDA excluding synergies. This further solidifies my belief that the market is significantly undervaluing Sleep Country at the current levels.

Confirmation Bias: people’s tendency to process information by looking for, or interpreting, information that is consistent with their existing beliefs.

“Preconceptions and priors: When you start on the valuation of a company, you almost never start with a blank slate. Instead, your valuation is shaped by your prior views of the company in question.” - Damodaran

Disclaimer: Fairway Research deep dives are not investment advice. Do your own due diligence.

I recently published a deep dive on SDI Group plc. Having spent over 70 hours researching and writing about the mini-conglomerate, I concluded that it is slightly overvalued for me. I say for me because I have a different risk tolerance than you. Given the information I presented in the 7,000 word1 write-up, and combined with your due diligence, you might have come to a different conclusion. Or you might not care about the valuation at all. That is your investing style and I respect that. Investing is different for everyone. There is no one-size-fits-all approach. But why publish deep dives in the first place?

I enjoy the research process

I simply enjoy learning about new businesses and valuing them. I feel with my 12 years of experience in M&A and professional valuations I bring an informed opinion to my readers. In my head, I try to approach each deep dive as a business writer/researcher or journalist would. I will admit that the creative process around business research excites me. It has something to do with bringing structure to financial information.

Knowledge compounds

Similarly - “No investor ever looks at the same company twice, for it is not the same company and he is not the same investor.” Knowledge compounds. Companies grow, enter new markets, launch new products, and hire different management teams.

Studying different businesses gives you benchmarks. For example, once I’ve researched Aritzia and know that they spend $3 million on opening a new store and have revenue of $1,000 per Sq. ft., the next time I look at an apparel retail business, I will have a yardstick to compare which will enable me to ask better questions. I also feel early on in one’s investing journey, studying mediocre businesses, is often as important as studying good businesses.

My Deep-Dive Process

For a business to be deep dive worthy, it needs to pass certain surface-level criteria. First, the company needs to be simple to understand (or with reasonable effort). Second, it should have stable or growing financials, with a return on invested capital higher than 15%. Third, it should have reasonable debt levels. It should also trade at a reasonable EBITDA multiple. If it trades at 80x EBITDA, I’m not touching it. Lastly, the most subjective one, I need to find it interesting.

Often that is also how I structure the deep-dive reports. I assume the reader is starting from a blank slate. First, I write about the business discussing its products, services, acquisitions, etc. I then discuss, in detail, the financial history of the business, management’s background, compensation structure, and capital allocation. Those 3-4 sections are often 80-90% of the deep dive content. But only after having written all these sections, and having spent a considerable amount of time reviewing documents, do I open a new tab in Excel and rename it as “DCF”. This is how I try to manage my own confirmation bias.

A DCF modeled without having gone through the process of understanding the business and financials is just numbers on a sheet. Remember the often over-quoted ‘Garbage in, garbage out’ analogy about DCFs? By the time I reach my DCF valuation, I am often beyond the point of not publishing the deep dive. 80-90% of it is already written up. What is the incentive for me to not publish? If my DCF says it is overvalued, then so be it. The company simply enters my ‘informed watchlist’, i.e., businesses I know well, but I’m not prepared to take a long position in as of now. I’ll still present a sensitivity table to help my readers evaluate a range of outcomes and come to their conclusions.

After I’ve written a deep dive, I simply share it with people who might be interested in what I write. I feel a sense of satisfaction in presenting my consolidated insights about the company in one place. I feel there should be one for every interesting company. Often readers write back with thoughts, counterpoints, queries about market shares, valuation assumptions, etc. Usually, it is a healthy and respectful discussion around the business.

I have no action bias

I am not compelled to publish ‘actionable’ deep dives. Patrick O'Shaughnessy publishes a brilliant podcast called ‘Business Breakdowns’. It is about great businesses, but often you can’t buy their stock because they are private. I’m trying to be a bit like Patrick.

To conclude, you will learn something from each of my deep dives but your portfolio might not look very different afterward. Maybe in the future the company will become undervalued. Maybe a comparable company will become cheap enough. Or a similar company in a different geography will come along with a more reasonable valuation. Possibilities are always there and we will be better prepared when they come along. One can argue that my approach yields a low return on time investment. Well, I’m in no hurry to get anywhere.

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A big welcome to over 350 new subscribers who joined Fairway Research since my last deep dive. Today we dive into SDI Group plc, a UK based serial acquirer of niche manufacturing businesses. If you would like to read the report in PDF (highly recommended) please click on the below link to download the report. I also recommend reading on a desktop or tablet for the best experience. Happy reading.

Fairway Research Sdi Group Plc Deep Dive April 2023

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Executive Summary:

SDI Group PLC (AIM: SDI) specializes in acquiring and operating niche manufacturing businesses in the life sciences, industrial, and scientific equipment and instruments sectors. Its revenue has grown considerably from £4.0 million in FY2014 to £49.6 million in FY2022, driven by the company's acquisition strategy. SDI operates in two primary business segments, Digital Imaging and Sensors & Control, and sells its products globally, with the UK, China, and Europe being its main markets.

SDI's management has been laser focused on acquiring businesses since FY2014, completing 16 acquisitions with a median deal size of £2.5 million and a median EV/EBIT multiple paid of 6.9x. The company targets a range of 4-6 times EBIT for new acquisitions. SDI's revenue growth has been a result of both organic and inorganic growth, with one-time Covid related orders for PCR machine products providing a significant boost to overall revenue in the past two years. However, this growth is expected to diminish in FY2024, which may negatively impact SDI's revenue growth, margins, and working capital.

Currently, SDI trades at an EV/LTM EBITDA multiple of 12.6x. However, excluding the EBITDA from one-time COVID-related revenue, the company effectively trades at 17.5x LTM EBITDA. To determine SDI's intrinsic value, we will use a discounted cash flow methodology to evaluate both its existing business and the potential value of acquisitions.

I conclude that while SDI's management has created an excellent mini-M&A machine, the current valuation is demanding. This is primarily due to the challenges SDI faces in meeting its high single-digit organic growth targets. Fairway Research does not hold a position in SDI Group.

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A. Introduction

In this report we take a deep dive into SDI Group PLC (AIM: SDI) (“SDI”). SDI is a serial acquirer of niche manufacturing businesses based in Cambridge, UK. SDI’s businesses primarily include design and manufacture of various medical, industrial and scientific equipment and instruments. Over the last 8 years, SDI has acquired 16 companies. growing its revenue several fold from £4.0 million in FY2014 to £49.6 million in FY2022.

For my readers, I want the core takeaways from this report to be a good understanding of SDI’s business and helping you think about valuing a serial acquirer in a logical way. SDI is currently covered by two issuer paid research houses, and I believe this independent analysis will give a useful perspective to SDI’s existing investors as well as those currently learning more about the company.

The main sections of the report are:

Section D: breaks down in detail the business of SDI’s two segments, including products, services, end markets, price points, competition etc. It includes a discussion on all 14 businesses of SDI.

Section E: discusses the acquisition strategy of SDI, including multiples paid for all the acquisitions to date.

Section F: discusses the financial performance of the past 5 years with an emphasis on organic and inorganic revenue growth and the impact of one-time Covid related revenue.

Section G: discusses management background, capital allocation and insider ownership.

Section H: focuses on my estimate of intrinsic value of SDI using a two-part discounted cash flow model.

Figures in the report are in British pounds unless otherwise noted.

B. Business History

SDI was founded in 2008 with two subsidiaries, Atik Cameras and Synoptics, both engaged in digital imaging. SDI got listed on AIM in 2008 itself, with the intention to use the listing as a means of doing acquisitions in the digital imaging space. At the time of the initial listing, it had a market capitalization of £5 million. SDI did not raise any money through the listing.

Things did not go as per plan as SDI’s performance repeatedly missed market expectations, and the market capitalization eventually dropped to £3 million.

At that time, Mike Creedon, with his background accounting and turnrounds, joined SDI as a finance director to handle the M&A function. However, the then CEO of SDI retired soon after Mike joined SDI, making Mike take up the interim CEO position. For the next several years Mike functioned as both the CEO and CFO of SDI until they finally hired a new CFO in July 2018.

In 2014, SDI started its current M&A strategy, which it refers to as the “buy and build” strategy with the acquisition of Opus Instruments. It soon became apparent that there were not enough targets in the digital imaging space for SDI to pursue a meaningful acquisition strategy. Accordingly, SDI started pursuing targets in the broader scientific products space with a manufacturing bias which led to the formation of the Sensors and Control segment.

Initially the company resorted to issuing equity in order to facilitate the acquisitions, however, as SDI’s cash flows and debt capacity have increased, it has pivoted to using internal cash flow and debt for making new acquisitions. As of March 2023, SDI has acquired 16 different businesses.

C. Stock Performance

Over the previous 5 years, SDI has vastly outperformed the FTSE 250 index by returning at an annual CAGR of 37%. SDI has not paid dividends during its existence.

D. Understanding SDI’s Business

SDI divides its business primarily into two business segments, i.e., Digital Imaging Segment and Sensors & Control Segment. A common theme among SDI’s businesses is that they are marketed primarily to laboratories, medical and scientific markets.

At a very high level, the Digital Imaging Segment includes products such as high-performance cameras which are used in astronomy, industrial and life sciences applications (such as covid-19 testing PCR machines) and art conservation. It also includes products such as optics for microscopes and systems for gel documentation etc. For the last twelve months (“LTM”) ended October 31, 2022, the Digital Imaging Segment had revenue of £22.6 million and contributed 40% of SDI’s total revenue. SDI’s Digital Imaging segment benefited from the one-time orders for Atik cameras used in OEM manufactured PCR machines.

The Sensors and Controls Segment includes various products used in life sciences, medical and industrial markets. These include electrochemical sensors, chemical dosing systems, chillers, coolers and heat exchangers, flowmeters, lab cabinets, metal enclosures, sterilizers and anti-static products. For the LTM period ended October 31, 2022, the Sensors and Control Segment had revenue of £34.1 million and contributed 60% of SDI’s total revenue.

Figure 1: SDI Group Overview:

Note that ATC and Thermal Exchange merged in 2020.

While SDI’s businesses focus on very niche markets, its products are sold worldwide. SDI’s main sales geographies are the UK (43% of total revenue), China (22%), and Europe (15%).

Figure 2: SDI Group Global Presence

Figure 3: Geographic Revenue Bifurcation (FY2022)

We will now discuss the two segments and the various divisions within them in more detail. However, if you only wish to get a quick summary of various businesses of SDI see Figure 4 below. Another great way to understand SDI’s portfolio is to go this their link on their website, which has a listing as well as a small business description of all SDI businesses.

Figure 4: Short Business Descriptions

1. Digital Imaging Segment

The Digital Imaging Segment consists of three main divisions, i.e., Atik Cameras, Synoptics and Graticules Optics. We discuss these in detail below.

i. Atik Cameras Division

Atik Cameras manufactures cameras which are used for life sciences and industrial applications, deep-sky astronomy and flat panel display inspection. These are highly sensitive and high-performance cameras which are currently offered under two main brands, Atik and Quantum Scientific Imaging (QSI, acquired in FY2018). During Covid-19, Atik cameras were in demand for use in real-time PCR machines for detecting viruses. In 2018, SDI had disclosed that around 75% of Atik Camera sales were to OEMs.

While Atik is one of the top European astronomy camera manufacturers, it faces competition from Chinese manufacturers such as QHY, SBIG, ZWO. Atik and QSI cameras are sold anywhere between $1,300 to $8,000.

Under the Opus Instruments brand (acquired in FY2014), Atik also produces cameras which are used in art conservation. Opus Instrument cameras use infrared reflectography techniques, are used to examine artworks at auction houses, galleries, conservation studios and educational establishments.

All three camera brands are manufactured in Atik’s Lisbon (Portugal) facility. For an overview of Atik’s production facility see this video.

ii. Synoptics Division

Synoptics offers a range of instruments under four brands.

Syngene: develops and manufactures systems and software for analyzing and imaging gels and blots. Syngene’s products include GBOX and NuGenius. Application of these products include DNA detection, protein analysis, multiplex imaging, and fluorescence-stained gels. Syngene’s systems utilize the Atik Camera’s range of products. The GBOX is priced at between $10K to $27K depending on the model and specifications, while the NuGenius is available for ~$7K.

Synbiosis: Synbiosis develops and manufactures a range of automated colony counting and zone sizing products for the microbiology laboratory in food, water, pharmaceutical and clinical applications. Its ProtoCOL 3 system is used in all the major pharmaceutical companies for vaccine and antibiotic development and its high-end system, AutoCOL is the world’s first fully automated colony counter. The ProtoCOL 3 is priced between $14K to $21K.

Synoptics Health: This division offers ProReveal which is a highly sensitive fluorescence-based patented protein detection test for checking the presence of residual protein on surgical instruments after going through a washer disinfector process. ProReveal is the only commercial test currently available that complies with UK Department of Health (DOH) guidelines.

Fistreem (acquired in FY2019): Fistreem designs and manufactures water purification products and vacuum ovens. The Fistreem water distillers produce general laboratory grade water, which is used in glassware rinsing and washing, general environmental analysis, cell culture preparation, clinical biochemistry etc. Fistreem products are priced between $5K and $12K.

iii. Graticules Optics Division (acquired in FY2019)

Graticules is a designer and manufacturer of eye pieces for microscopes. Its best-selling product is horizontal eye piece reticle priced between £52 and £75. These products are consumables for the customers and provide a recurring revenue stream for SDI.

2. Sensors and Control Segment

i. Sentek (acquired in FY2016)

Sentek is the UK’s largest independent manufacturer of electrochemical sensors. Sentek manufactures and markets off-the-shelf and custom-made electrochemical sensors for water-based applications. These sensors are used in laboratory analysis, in food, beverage and personal care manufacture, as well as the leisure industry. Sentek’s electrodes are either single/limited use or have a working life of only six – twelve months, and must be replaced regularly, providing a repeat business revenue model for the SDI Group. Sentek occasionally enters into long-term supply agreements with companies for supplying sensors and also markets them through distributors. Sentek’s electrodes are priced anywhere between £60 to £325.

As an example of Sentek’s product application, to maintain hygienic food safety standards, the food and beverage industry relies on quality electrochemical measurement using Sentek’s custom & OEM electrodes. Recreational swimming pools and hotels & resorts with swimming pools depend on accurate testing to ensure that the pool water is safe and contains the right chlorination.

ii. Astles Control Systems (acquired in FY2017)

Astles Control Systems is a supplier of chemical dosing and control systems to different manufacturing industries including manufacturers of beverage cans, engineering and motor components, white goods, architectural aluminium and steel. The company supplies equipment with an average product life of ten years, as well as repeat business consumables, and servicing, and repairs.

ACS utilises many of Sentek’s electrochemical sensors in its product range.

iii. Applied Thermal Control and Thermal Exchange (acquired in FY2018 and FY2019)

ATC manufactures and supplies chillers, coolers and heat exchangers used within industrial, medical and scientific markets. These products are required to protect instrumentation, improve analytical repeatability and stability or remove heat from chemical reactions. The products are generally sold through distributors.

ATC chillers are well established in the scientific instrument support markets (electron microscopes, X-ray diffraction, ICPMS etc.), semiconductor process, ophthalmic lens manufacturing equipment, machine tool, commercial digital printing and laser lithography markets worldwide.

In 2020, Applied Thermal Control was merged with another subsidiary of SDI, Thermal Exchange, which manufactures industrial cooling systems.

iv. MPB Industries (acquired in FY2019)

MPB designs, manufactures and sells a range of flowmeters and control instrumentation with applications in water treatment, power generation, gas and oil production, human medical anesthesia, aviation, pharmaceutical, pollution control, scientific analysis, educational and many other areas. MPB’s products helped in the manufacture of ventilators for the UK during the outbreak of Covid-19. MPB competes with companies such as ABB, Hitachi, Honeywell, and Siemens in the flow meter space.

v. Chell Instruments (acquired in FY2020)

Chell designs, manufactures and calibrates pressure, vacuum, and gas flow measurement instruments for a variety of sectors including aerospace, vehicle aerodynamics, gas and steam turbine testing and power generation industries. Chell supports a number of leading Formula 1 racing teams with high-precision measurement equipment for aerodynamic testing.

vi. Monmouth Scientific (acquired in FY2021)

Monmouth designs, manufactures and services clean air solutions specialising in cleanrooms, biological safety fume cupboards and laminar flow cabinets. Monmouth’s biological safety cabinets were used in Covid-19 testing laboratories. To know more about Monmouth’s business, watch this video.

vii. Uniform Engineering (acquired in FY2021)

Uniform is a manufacturer of metal enclosures and housings used in a variety of applications including pharmaceutical, laboratory and safety equipment. Uniform uses precision metal fabrication, metal bending and powder coasting techniques in the manufacture of its products.

viii. Scientific Vacuum Systems (acquired in FY2022)

SVS specialises in custom Physical Vapour Deposition systems for the deposition of thin film coatings typically on semiconductor wafers, for use in scientific research, industrial and semiconductor manufacturing applications. SVS is a market leader in the manufacture of production sputter coaters for premium brand razor blade coating.

ix. Safelab Systems (acquired in FY2022)

Safelab produces high specification fume cupboards and similar cabinets, for both commercial and research laboratories and with a special focus on the education sector which requires versatile and ducted cabinets often specified in newly built or refurbished laboratory facilities.

Safelab’s main customer base is schools, universities and other institutions where they require a flexible fume cupboard. They also sell to building contractors which build new educational institutes.

x. LTE Scientific (acquired in FY2023)

Specialises in the design and manufacture of sterilizers, decontamination and thermal processing equipment, used in the life science and medical market sectors. LTE manufactures autoclave sterilizers, which sterilize objects placed in a pressure vessel by injecting steam under pressure at temperatures ranging typically from 105˚C to 137˚C. These are used in laboratories and hospitals. Other manufactured products include environmental rooms and chambers, endoscope storage cabinets, laboratory ovens, incubators and drying cabinets.

xi. Fraser Anti-Static (acquired in FY2023)

Manufacturer of antistatic products which eliminate, clean, generate or measure static electricity in a variety of industries including plastics, packaging, printing, food processing, medical and pharma amongst others.

3. SDI products from a consumer perspective

As can be seen from above, SDI’s portfolio includes a wide variety of products which are predominantly sold to business customers in the medical, industrial and scientific space. Accordingly, it is important to understand whether SDI’s products are capital expenditures for its customers or recurring operating expenses. As per SDI’s management, roughly 35% to 40% of SDI’s revenue is recurring in nature. These includes products which are consumables and periodic servicing of various other products sold by SDI.

Figure 5: Nature of Expenditure for Customer

E. SDI’s Acquisition Strategy

In 2014, SDI started its ‘buy and build’ strategy which it has been executing at a brisk pace. Between FY2014 and H1 FY2023, SDI completed 16 acquisitions, with a median deal size of £2.5 million and a median EV / EBIT multiple paid of 6.9x. It targets to pay between 4-6 times EBIT for new acquisitions. SDI often uses contingent consideration as a means to bridge negotiation differences with seller and mitigate performance risk.

Figure 6: SDI Acquisition Strategy and Process

Figure 7: Historical Acquisitions by SDI Group

Sourcing of acquisitions

SDI generally sources acquisitions through three routes:

1)      using an intermediatory such as a corporate finance firm / business broker.

2)      by asking internally who they should target to buy.

3)      Having a reputation of being a good acquirer focused on helping owners get an exit, at the same time being a good home for the employees. SDI offers the potential seller(s) as a reference a meeting with the owners of businesses who have sold to SDI over the years.

Due diligence process

Mike Creedon does the due diligence for each acquisition himself. He sometimes takes the support on internal resources to help kick the tires on a new business.

Financing of acquisitions

Initially, SDI used to raise equity for completing acquisitions. However, once SDI had sufficient cash flows and debt capacity, it used those for new acquisitions. Out of the 16 acquisitions, SDI raised equity for three acquisitions, i.e., Sentek (October 2015), Astles Controls Systems (January 2017) and Graticules Optics (February 2019). Most importantly it has not raised outside equity post February 2019. Occasionally, when sellers wanted ownership in SDI, it issued a nominal number of shares as part consideration.

Figure 8: SDI Group Shares Outstanding

Post Acquisition Operations and Synergies

Post acquisition, SDI’s businesses operate autonomously as separate entities with support from the head office. SDI currently has 14 different business units. SDI also introduces stronger financial controls because prior to the acquisition most businesses have unaudited financials. The subsidiary managers/ directors prepare operational reports and budgets which are then consolidated at the head office level. The head office monitors the operations at a business level rather than at a segment level. About 70% of founders who sell their businesses to SDI stay on in some capacity even after selling to SDI. They are incentivized through an arm’s length salary and a bonus based on business performance.

The head office, which is only three people currently, also facilitates cross sharing of information between the business. Mike Creedon tries to visit the subsidiaries every six weeks and is on the road four days a week. Of course, there are synergy opportunities upon integration as well. As mentioned earlier, the outputs of some businesses are the inputs of others. For example, the cameras produced by Atik are used in the gel documentation machines produced by Synoptics.

Wherever it made a lot of sense to operate as a single unit, SDI has combined the operations. For example, Opus Instruments and QSI were merged into Atik Cameras and now all three are manufactured in Atik’s Lisbon facility. Fistreem was merged into Synoptics and Thermal Exchange and Applied Thermal Controls were also merged.

Here is a good concluding statement on SDI’s M&A strategy by the CEO:

F. SDI’s Historical Financial Performance

Figure 9: SDI Group Historical Financial Performance

1. Revenue growth

SDI’s overall revenue has grown from £14.5 million in FY2018 to £49.7 million in FY2022 at a compounded annual growth rate (“CAGR”) of 36%. This was driven by growth in both the segments. The Digital Imaging segment grew at a CAGR of 29%, and the Sensors and Control segment grew at a CAGR of 42%. In order to understand SDI’s phenomenal revenue growth, we must understand two important points about the revenue growth.

1.      First, since SDI is a serial acquirer, we have to differentiate between organic revenue growth and acquired revenue growth.

2.      Secondly, since SDI benefited from one-time sales during the pandemic (Atik cameras for PCR machines and flow meters for ventilators) we have to understand the growth excluding these one-time sales.

Organic vs. Acquired Revenue Growth

SDI’s management target for organic revenue growth is high single digits. SDI has met this target in three out of the last five years. It witnessed only 5% organic growth in FY2019 and 3.7% in FY2020. As can be seen from Figure 10 below, naturally majority of SDI’s revenue growth came from acquisitions.

Figure 10: Organic vs Inorganic Revenue Growth

Note that SDI’s management quoted 19% organic revenue growth in FY2021. However, that calculation seems to include revenue increase from FY2020 acquisitions. After excluding revenue from FY2020 acquisitions, organic revenue growth was 8.6% instead of 19%. In H1 FY2023, SDI’s organic growth decreased to 3.8%. SDI’s management attributed this to slower post Covid uptick at Monmouth and components delays at Astles and Chell.

One-Time Covid Related Sales

Figure 11: SDI FY2021 and FY2022 Revenue Bridge

Figure 12: FY2021 and FY2022 Revenue Growth Breakdown (Covid-19 Growth Broken Out)

SDI had £6.1 million of one-time Covid related revenue in FY2021, which grew to £8 million in FY2022. During the LTM period ended October 2022, the Covid related one-time revenue was £8.7 million. This revenue primarily related to two SDI businesses, i.e., Atik Cameras which supplied high performance cameras to a Chinese OEM for use in PCR machines, and second was flowmeters provided by MPB Industries for ventilators. The FY2022 revenue of £8 million only relates to Atik cameras.

Figure 13: SDI Group PLC Revenue Breakdown for FY2021 and FY2022

SDI’s management have highlighted at various points that this revenue will likely go away in FY2024. Accordingly, as investors it becomes extremely important to adjust for this one-time revenue when projecting SDI’s revenue and margins for future years. It also becomes critical to analyze SDI’s effective trading multiple after adjusting for one-time covid related sales and EBITDA. In my DCF valuation, I have specifically made an adjustment for these one-time covid related sales. Below are some quotes from the management on the one-time revenue:

In the most recent earnings call, Ami Sharma the new CFO of SDI made the following statements:

As I will discuss in the Valuation section, because this £8 to £9 million of one-time revenue will go away, it will have a considerable impact on SDI revenue and EBITDA for FY2024. While revenue growth might still be seen in FY2024 due to full year impact of FY2023 acquisitions and new FY2024 acquisitions, I expect overall revenue growth to be muted in FY2024. I discuss this in more detail in the Valuation Section.

Revenue bifurcation

As SDI has been making more acquisitions in the Sensors and Control segment, its revenue share has grown from 47% of total revenue in FY2018 to 60% of total revenue in the LTM period ended October 2022.

In terms of geographic revenue, SDI’s share of revenue from UK has increased from 34% in FY2018 to 43% in FY2022. This is probably due to most acquisitions being UK based. However, the more notable change is that share of Asia sales has increased from 23% in FY2018 to 31% in FY2022. Out of the 31%, 22% of sales are in China and 9% in Asia (Ex. China). These increases in shares for UK and Asia have come at the expense of Americas and Europe, both of which have shrunk since FY2018. However, once we adjust for one-time sales of Atik Camera’s to the Chinese PCR manufacturer, the share of Asia falls to 18% (China 7%).

Figure 14: Geographic Revenue Evolution

2. Operating Expenses

i. Cost of goods sold (COGS)

SDI’s COGS has been within a tight range of 32% to 37% during the last 5 years. This has helped SDI maintain steady gross profits levels in mid to high 60’s. Because each of SDI’s businesses are different, COGS does not seem to be dependent on one specific raw material input such as steel.

ii. Wages and Salaries

One of SDI’s main expenses is its employee costs which have on average been close to 32% of revenue in the last 5 years. Wages and salaries cost gets included on COGS and SG&A but is also reported separately in the notes to accounts. SDI’s businesses have labour intensive manufacturing processes. Out of 354 average total employees in FY2022, 193 or 55% were employed in production. Fortunately, SDI seems to have managed average salaries well in an inflationary environment. SDI average annual employee salary has stayed close to £40K over the last 5 years.

Figure 15: SDI Wages and Salaries

iii. EBITDA

SDI’s EBITDA margin has increased from 21% of revenue in FY2018 to 26% during the LTM period ended October 2022. This has primarily been driven by a decrease in SG&A costs as a % of revenue from 54% of revenue in FY2018 to 43% of revenue during the LTM period. Note that SDI has achieved this EBITDA margin increase despite slightly decreasing gross margins.

In terms EBITDA margins for SDI Segments, the Digital Imaging Segment has significantly higher EBITDA margins, at ~42%, as compared to the Sensors and Control segment which has EBITDA margins of ~19%. Since, the margins for the Digital Imaging segment have improved during the covid period, it likely indicates that the improvement in margins is linked to increase in one-time covid revenue for Atik Cameras. Note that prior to FY2021, the EBITDA margins for both the segments of SDI were similar at ~25%. Accordingly, once the £8 million of one-time revenue goes away, the Digital Imaging EBITDA margin will likely see some downward normalization. In my DCF analysis, assume the EBITDA margin on one-time covid related revenue of £8 million, is 42%, which will likely not repeat FY2024 onwards.

Figure 16: Segment EBITDA Margins (before corporate costs)

Segment EBITDA margins are computed by adding depreciation to segment adjusted operating profit.

4. Working Capital and Capital Expenditures

Working Capital

Prior to FY2021, SDI used to have a positive working capital position ranging between 11% to 14% of revenue. Working capital mainly composed of accounts receivable and inventories. However, during FY2021 and FY2022 SDI received full down payments for covid related sales to Chinese OEM manufacturer for Atik cameras which resulted in negative working capital during those years. As expected, the working capital position has quickly turned back to positive as of October 31, 2022, to 9% of revenue.

Figure 17: SDI Working Capital Levels

Capital Expenditures

SDI had average annual capital expenditure of ~4% of revenue. For the LTM period SDI had capital expenditures of £1,842K.

5. Return on Invested Capital

Figure 18: SDI’s Return on Invested Capital

SDI’s return on invested capital has improved significantly in recent years. From the respectable levels of 19% witnessed in FY2019 and FY2020 to 26% in FY2021 and 32% in FY2022. While ROIC has improved, it is important to note that a negative working capital position, due to the downpayment of one-time covid related order has skewed the return on capital upward. If SDI’s working capital at stayed had the same amount in FY2021 and FY2022 as at the end of FY2020, the ROIC for FY2021 would have been 24% and FY2022 would have been 28%. A noticeable improvement, nonetheless.

SDI buys companies at a median multiple 6.9x of EBIT. That simply translates to a ROIC of ~15%. This of course can be improved after realization of post-acquisition synergies. Naturally, the lower the multiple paid, or higher the synergies, the higher the ROIC.

G. Management

Mike Creedon - CEO

Personally, I am a fan of Mike’s humility. If you read or watch any of Mike’s interviews (see Section L -Useful Resources), you will notice that Mike is humble executive minus all the fluff which comes from management these days. He says things as they are. Before we get more into Mike’s background and how he built SDI, I request you to briefly look at this video for 30 seconds on how he likes to start the conference calls by showing off SDI’s modest head office setup. I enjoy it because I take it as a sign of the stewardship he feels towards the shareholders of SDI.

As mentioned before, Mike joined SDI when it was in pretty much in shambles. Stock was down 50% since listing no AIM, and the envisioned ‘buy and build’ strategy did not even get of the gate. Once he became the interim CEO, Mike started working along side the Chairman of SDI, Ken Ford, and slowly turned the business around over the next few years. In 2014, they made their first acquisition, Opus Instruments, and since then SDI has not looked back, completing 16 acquisitions in 8 years.

Prior Experience

Prior to SDI, Mike served as Finance Director at Innovision Limited, a subsidiary of the NASDAQ listed company, Leitch Technology Corp and as Finance Director of Ninth Floor plc, a company formerly on the Official List.

In 2006 Mike was appointed as Interim Finance Director at NextGen Group plc, an AIM listed company focusing on the design, manufacture and sale of services and equipment to the biotechnology and pharmaceutical sector, following which Mike acted as Chief Financial Officer at Durham Scientific Crystals Limited, a company whose principal activity is the development, manufacture and sale of products for the x-ray imaging market.

Personal Interests

Mike is a chartered accountant and earned his MBA from Henley Management College. He reads 40-50 fiction books per year and travels to various subsidiaries for 4 days a week in a rented petrol car. He personally drives a pick-up truck, is fond of tennis and horse riding. His favourite business books are Warren Buffet’s biography, Snowball, and his letters to shareholders of Berkshire Hathaway. He is an admirer of Judges Scientific, which some consider as a larger comparable of SDI and is following a similar acquisition strategy. Mike is also an admirer of Mark Leonard’s approach to M&A at Constellation Software.

Day-to-Day role at SDI

Mike describes his role as being two-fold:

1) Being on the road for four days a week (in a rented car) and travelling to various subsidiaries of SDI to meet with the people. He tries to visit each subsidiary within a period of 6 weeks.

2) Being responsible for M&A. Given his accounting training and turnaround experience, Mike carries out all due diligence on new transactions himself.

1. Capital Allocation

SDI’s management has been laser focused on acquisitions since FY2014. In the last 5 years, almost the entire cash flow from operations of £30 million has been reinvested into new acquisitions. Another £5.6 million has been reinvested into the business in form of capital expenditures. SDI has raised minimal amount of new debt between FY2018 and FY2022. However, note that as of October 31, 2022, SDI’s debt increased to £19 million to fund the LTE Scientific and Fraser Anti-Static acquisitions during FY2023.

Figure 19: 5-Year Capital Allocation of Summary

2. Ownership and Compensation

One of the biggest criticisms of SDI’s management from the investor community is the low insider shareholding. Mike Creedon currently owns 172.5K shares of SDI, which comes to about 0.17% of total shares outstanding. He recently sold a chunk of his shares, because Danske Bank wanted to buy 5% stake in SDI but there was no liquidity in the stock. Further some of the employees who had initially agreed to sell the stock, backed out at the last minute because they felt the stock price was not high enough. So, Mike sold some of his shares and gave some of the proceeds to his kids to help them ‘on the housing ladder’. No wealth diversification logic here. Mike has repeatedly mentioned that he is not motivated by wealth, but he loves his job.

It is important to note that Mike spear headed SDI from £2.5 million to £170 million in market capitalization. Any executive in that case would have loved to own more, but this is what Mike had to say about his low ownership in SDI:

Mike’s own remuneration has grown over the last 5 years; however, SDI’s profits have grown at much faster pace. Mike’s compensation as a % of net profit actually decreased from 11% in FY2018 and FY2019 to 4% FY2022.

Figure 20: Mike Creedon’s Remuneration

SDI has a long-term incentive plan (“LTIP”) in place for its management team. Performance conditions are based for 50% on the growth in fully diluted earnings per share and for 50% on the total shareholder return over three years for SDI shareholders compared with a basket of twenty comparable companies.

As of April 2022, Mike had options on another 774K shares of SDI including 63K share entitlements under the LTIP. The exercise price of the ordinary options ranges from £0.172 to £1.740, and of LTIP options is £0.010.

Since Mike has been so important to building up SDI, as an investor, one cannot ignore keyman risk. Here is what his response was when asked whether there is a risk that he might leave.

H. Valuation

SDI currently trades at an EV / LTM EBITDA multiple of 12.6x, based on the LTM EBITDA of £14.9 million. However, it is important to note that £8.7 million of the LTM revenue was one-time covid revenue for Atik Cameras, which we have already discussed in detail. If we assume that SDI earned 42% EBITDA margin on that revenue (in line with Digital Imaging segment’s LTM EBITDA margin), the covid adjusted LTM EBITDA actually comes down to £10.7 million. This adjusted EBITDA implied a traded EV / EBITDA multiple of 17.5x. Accordingly, what might seem like a fairly valued company at 13x EBITDA, is effectively trading at around a 40% higher multiple of 17.5x. In comparison, Judges Scientific plc (£623 million EV) currently trades at 20x LTM EBITDA, and Halma plc  (£8.7 billion EV) trades at 24x LTM EBITDA.

Figure 21: Market Valuation of SDI

Intrinsic Value Methodology

Valuing a serial acquirer is always challenging. I have a simple framework of thinking about the valuation of a serial acquirer such as SDI. This basically involves two steps:

1. Valuing the existing business: We first value SDI’s existing business as of today. That is, we value SDI’s business including all acquisitions which SDI has completed up to date. We take a conservative level of organic growth. However, for this step, we assume SDI’s stops acquiring new businesses going forward. This gives us a level of stable free cash flow that can be generated by the existing business, helping us access the intrinsic value of the ‘as-is’ SDI and also understand the amount of free cash flow which can be invested towards new acquisitions in step 2. We also adjust for net debt from the existing business.

2. Valuing the new acquisitions potential: In the second step, we take the free cash flows of the existing business and using by certain assumptions such as percentage of free cash flow invested in acquisitions, multiple of EBIT paid, and organic growth rate in EBIT post acquisitions, try to compute the intrinsic value which can be generated from new acquisitions over the next 4-5 years.

Summing up these two intrinsic value estimates gives us the overall intrinsic value of SDI.

Key assumptions

SDI’s Existing Business DCF Assumptions

1. We first make a downward adjustment to SDI Digital Imaging historical revenue for covid related one-time sales of £8 million in FY2022 and £8.7 million for the LTM period ended October 2022. Then we take an assumption of 5% annual organic revenue growth. This assumption is based on:

a. SDI management’s target organic growth rate of high single digits.

b. SDI missed this organic growth target in FY2019 (5.0% organic growth), FY2020 (3.7% organic growth). Further, excluding covid one-time sales, SDI’s organic revenue decreased by 16% in FY2021.

c. SDI’s organic revenue growth in H1 FY2023 was only 3.8%. In fact, after adjusting for Covid related revenue, the organic growth in H1 FY2023 was ~1%.

Accordingly, I believe a 5% organic revenue growth is a reasonable assumption to take.

2. We also take a 5% organic growth in Sensors and Control segment for the above reasons.

3. We assume that SDI will ship another $4 million of Atik Cameras to the Chinese PCR manufacturer in H2 FY2023, and separately add the EBITDA (net of tax) from that order to SDI’s enterprise value.

4. We adjust for the full impact of FY2022 (Safelab and Scientific Vacuum Systems) and FY2023 (LTE Scientific and Fraser Anti-Static) acquisitions.

5. We assume that SDI’s digital imaging and sensors and control segments will maintain the EBITDA margins at the levels witnesses during the LTM period ending October 2022.

6. Maintenance capital expenditure of 3% of revenue. This is slightly lower than the average of 4% during the last 5 years.

7. Working capital stabilized at 12% of revenue, in line with levels seen prior to FY2021.

8. UK tax rate of 25%.

9. Discount rate of 10%.

10.  Exit EV / EBITDA multiple of 12x. Conservatively assuming a lower exit multiple as SDI currently trades close to 13x LTM EBITDA.

For more details, refer to the discounted cash flow model included in the PDF report.

Figure 22 below includes the revenue projections of SDI’s existing business.

Figure 22: SDI Projected Revenue of Existing Business

Based on the above assumptions the intrinsic value per share of SDI’s existing business is £1.14.

Figure 23: Sensitivity Analysis on SDI’s Existing Business Value per Share (£)

New Acquisitions Value

SDI’s New Acquisitions DCF Assumptions

1. SDI invests 80% of the free cash from existing business for new acquisitions.

2. Acquisitions are completed at an EV / EBIT multiple of 6x. This is lower than the median multiple of 6.9x paid by SDI for historical acquisitions. However, I assume that SDI will be able to realize synergies after the acquisition effectively lowering the EV / EBIT multiple paid for target companies.

3. Organic growth of 5% in EBIT for the acquired businesses (in line with the existing businesses).

4. New businesses are acquired in the middle of the financial year.

5. Capex and depreciation are equal to each other.

6. No additional working capital required.

7. Acquisitions related cost of 5% of price.

8. Discount rate of 10%.

9. Exit EV/ EBIT multiple of 15x.

10.  We don’t consider the additional leverage which SDI might take to carry out the acquisitions.

Figure 24: Projected Free Cash Flow from New Acquisitions

Based on the above assumptions the intrinsic value per share of new acquisitions is £0.25.

Figure 25: Sensitivity Analysis on Intrinsic Value Per Share from New Acquisitions (£)

Valuation Summary

Figure 26: SDI Valuation Summary

Based on the above analysis the intrinsic value per share of SDI is £1.39, which is 16% below the current share price of £1.65. However, as investors might have different risk tolerances and viewpoints on SDI’s business, such as a higher assumption on organic growth, you can sum up the different values from sensitivity tables in Figure 23 and Figure 25 to come to your own estimate of intrinsic value. For example, it is not difficult to see a scenario in which SDI is valued fairly. An 8% revenue growth rate during the next 5 years in existing and acquired businesses, while paying 6x EBIT multiple for new acquisitions, the intrinsic value per share reaches close to £1.60. I will leave it to you to decide what the fair valuation of SDI is for you. Because of the reasons I discussed earlier, growing at 8% organically would be challenging, and 5% seems more reasonable. Accordingly, SDI currently does not present a compelling entry point.

Figure 27: SDI Valuation Summary Graph (£)

I. Risks

Key man risk: There is an element of key man risk with the possibility that Mike Creedon might leave. However, all subsidiaries of SDI function autonomously with their own managements. What would be impacted is the M&A function which Mike is heavily involved in. The new CFO, Ami Sharma, comes from an acquisitive company which helps mitigate the risk to some extent. However, low insider ownership increases this risk.

Wrong acquisition risk: SDI has recently started doing larger acquisitions. If SDI acquires a terrible business, it can weigh down the current cash flows. This risk is present is all serial acquirers.

Lack of precise market data: Due to the niche nature of SDI’s businesses, it is often not possible to know exactly who the competitors are or the estimated market size of the industries. In other words, when SDI claims that it is the market leader in ‘xyz’ product, it is difficult to corroborate the same through independent data sources.

Exposure of customer capex cycle: Around 60% to 65% of SDI’s revenue is one-time capital expenditure for its customers making it prone to discretionary spending risk.

Technological risk: if SDI is not able to innovate or keep up with new technologies within medical and scientific equipment, the business can become challenging. This risk is especially present for the business such as Atik Cameras.

J. Conclusion

SDI’s management has done a commendable job of building a truly diversified manufacturing mini-conglomerate. The company has been self funding acquisitions helping it build immense shareholders value. Mike Creedon is a great M&A focused CEO with a terrific capital allocation record. Unfortunately, SDI currently trades above my intrinsic value estimate. Either its price would have to correct downwards, or fundamentals would need to improve a lot (without price changing much) for me to see a sufficient margin of safety. Therefore, I will continue to monitor SDI's performance closely.

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K. Useful Resources

Mike Creedon Interviews:

Inpractise Interview: SDI Group: Niche Manufacturing Serial Acquirer | In Practise

Acquirers.com Interview: SDI Group Interview – Early days of the Halma model (acquirers.com)

Andrew Brown Interview: (1) SDI Group CEO Mike Creedon Interview - YouTube

Earnings Calls:

SDI GROUP PLC - Full Year Results - YouTube

Issuer Paid Analyst Reports:

Equity Research - SDI Group

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Thank you for reading. Please share any comments or suggestions below. You can also write to me at Fairwayresearch@gmail.com or find me on Twitter. Fairway Research’s goal is to do a tremendous amount of research on a small group of companies. So if the newsletter is adding value to you or your team, please share it with your friends and colleagues. I enjoyed researching SDI and I hope you liked learning more about it. By the way, here is a picture of my cluttered desk as I finish publishing this deep dive.

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Today we take a deep dive into Information Services Corp (TSX:ISV). If you like moats, free cash flow, high ROIC stable boring businesses, then ISC is definetly worth a read. I hope you like the report. As always, if you wish you view this report in PDF (recommended) then please click below:

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A. Executive Summary

ISC is a former crown corporation that provides registry and information management services and has an exclusive contract with the government of Saskatchewan for handling registries up to 2033. The Government’s 30% equity interest ensures high chances of contract renewal beyond 2033.

The Registries business has acted as the cash flow engine of ISC helping it spend over $200 million on eight acquisitions of businesses in related verticals, diversifying revenue and EBITDA profiles.

During the last 5 years, ISC has more than doubled its revenue from $93.6 million in 2017 to $188 million during the last twelve months. At the same time, EBITDA has also more than doubled from $32 million to $67 million.

ISC divides its business into 3 main segments, Registry Operations, Services, and Technology Solutions. Registry Operations and Services both contributed 48% each to the total revenue of ISC. The Technology Solutions segment contributed only 4% to ISC’s total revenue. Around 70% of ISC’s EBITDA is still driven by the Registries Operation segment.

The management of ISC is highly experienced, has a good M&A track record, has shown commendable cost management while integrating acquisitions, and is aligned with shareholders in terms of compensation plans.

ISC’s business has several attractive characteristics such as:

• Registries business is an effective monopoly in Saskatchewan

• Minimal reinvestment is required in terms of maintenance capital expenditures

• Negative working capital since the IPO

• New acquisitions are financed through internal cash or conservative use of debt.

Because of these characteristics, ISC’s business consistently generates returns on invested capital of over 30%.

ISC’s stock currently trades at 6.6x LTM EBITDA, which is the lowest multiple levels it has traded at since its IPO in 2013. Using conservative cash flow assumptions, a 10% discount rate, and a 2% long-term growth rate, my discounted cash flow indicates that ISC’s intrinsic value per share is close to $29 per share. This represents a 30% upside from the current share price of $22.57.

In this report, we take a deep dive into ISC’s history, business segments, acquisitions, historical performance, management’s capital allocation, and valuation.

My other deep dives are available on Fairwayresearch.substack.com.

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B. Introduction

Headquartered in Regina, Saskatchewan, ISC provides registry and information management services for public data and records. Most importantly ISC has a 20-year master services agreement (“MSA”) with the government of Saskatchewan for handling land, personal property, and corporate registry for the province. For the last twelve months ended September 30, 2022 (“LTM”), ISC had revenue of $188 million. ISC had 400 employees as of the end of 2021. ISC trades on the Toronto Stock Exchange under the ticker “ISV” and has a market capitalization of $400 million.

Figures in the report are in Canadian dollars unless otherwise noted.

C. Business History

1. Pre-IPO (2000 to 2013)

Information Services Corporation (“ISC”) was first created as a Saskatchewan Provincial Crown Corporation on January 1, 2000. The company was responsible for the administration of the Land Registry system as well as the Land Survey for various provincial departments. Additionally, in 2001 ISC also became responsible for the personal property registry in Saskatchewan and in 2010 it also took over the corporate registry function. In May 2013, right before its IPO, ISC transitioned to being a private corporation and signed a 20-year MSA with the Saskatchewan government for the provision of registry services.

Figure 1: ISC Business History (PRE-IPO)

2. Post-IPO (2013 to 2023)

Between 2013 and early 2023, ISC diversified its business away from Saskatchewan registries. At the time of its IPO, ISC’s entire $80 million revenue consisted of Saskatchewan registries and by 2021 registries only represented 51% of ISC’s total revenue. ISC achieved this by acquiring nine companies within two new business segments, i.e., Services and Technology Solutions. However, ISC is still quite dependent on the Registry Operations segment when it comes to EBITDA. For the last twelve months (“LTM”) ended September 30, 2022, the Registry Operations segment contributed more than 70% of the reported EBITDA of ISC (that is even after loading the corporate expenses entirely to the Registry Operations segment). I discuss this in more detail in the next section.

Figure 2: ISC Revenue Evolution

Logos in Figure 2 represent acquisitions.

D. Stock Performance

Figure 3: ISC Stock Return since IPO

Since its IPO in 2013, $10,000 invested in ISC has turned into $21,652 at an annual return of 8.33%. During the same period, $10,000 invested in the TSX Composite Index turned to $16,738 at an annual return of 5.48%.

E. Understanding ISC’s Business and Acquisitions

NOTE TO READER: In this section, I discuss the various business segments of ISC and the major acquisitions over the last 8 years within each segment. While, in my other deep-dive reports, acquisitions have had a dedicated section, with ISC I felt it is best to introduce the acquisitions when the reader is trying to understand the business segments. The reason for this is that the ISC’s acquisitions themselves are creating new Segments and Sub-segments.

For each of the major acquisitions I analyze the business of the target company, management’s rationale of the transaction, acquisition pricing, financing, post-acquisition performance of the target within ISC, and my overall remarks.

ISC divides its business into 3 main segments, Registry Operations, Services, and Technology Solutions. Registry Operations and Services both contributed 48% each to the total revenue of ISC. The Technology Solutions segment contributed only 4% to ISC’s total revenue. The Registry Operations segment is the legacy Saskatchewan registry business of ISC. The Services and Technology Solutions segments have been built through acquisitions. In this section, we will dive into the products and services, historical performance, and relevant acquisitions for each of the segments.

Figure 4: ISC Business Breakdown

1. Registry Operations Segment – The Crown Jewel of ISC

The Registries Operations segment is the legacy business, the cash cow, and the crown jewel of ISC. It operates registries and related services on behalf of two provincial governments in Canada (Saskatchewan and Ontario). Through this segment, ISC provides registry and information services on behalf of the Province of Saskatchewan under a 20-year MSA, in effect until 2033, and is the exclusive provider of the Saskatchewan Land Registry, the Saskatchewan Personal Property Registry, the Saskatchewan Corporate Registry.

In June 2022, ISC entered Ontario property tax services through the acquisition of Reamined which has an exclusive agreement with the Province of Ontario to provide property tax infrastructure and services to over 440 municipalities in Ontario, facilitating the management of property tax rates and distribution.

There are no competitors to ISC in Saskatchewan, but Teranet, an OMERS portfolio company manages registries for Ontario and Manitoba. Only three provinces have fully privatized the operation of their land registries. Manitoba and Ontario pursued privatization through partnerships with Teranet. The company began in 1990 as a public-private partnership created by the Ontario government. Since 2008, Teranet has been wholly owned by the Ontario Municipal Employees Retirement System (OMERS). In 2014, Teranet entered a full-concession exclusive license to operate the land registry in Manitoba. Saskatchewan’s land registry is operated by the ISC which began as a Crown corporation but became a publicly listed company in 2013. British Columbia has adopted somewhat of a hybrid, semi-privatized model whereby the land title and survey authority operates as a statutory corporation.

Overall, the Registry Operations segment is a low or flat-growth business with high margins. As the majority of the revenue of Registry Operations comes from the land registry sub-segment (See Figure 5), the real estate activity in Saskatchewan is a major driver of revenue. The services in this segment are provided under ISC and Reamined brand names.

Figure 5: Registry Operations Revenue by Sub-Segment

I will now discuss each of the above sub-segments within Registry Operations in detail.

i. Land titles registry (70% of Registry Operations revenue)

The Land Titles Registry issues titles to land and registers transactions affecting titles, including changes of ownership and the registration of interests in land, in Saskatchewan. The Land Titles Registry provides land ownership information to support new and used home sales, land and home development transfers, and other value-added transactions. Its primary users include law firms, financial institutions, developers, and resource companies. Revenue for the Land Titles Registry is earned through registration, search, and maintenance fees (registration is more than 80%). Registration fees are either a flat fee or value-based, calculated as a percentage of the value of the land and/or property being registered (0.3% as per MSA). ISC typically charges a flat fee per transaction for search and maintenance transactions. As per the MSA, the fees increase each year as per Saskatchewan CPI figures (June to June period). 60% to 70% of land registry revenue is ad valorem (0.3% of value). Nearly 86 percent of all Land Titles Registry registration transactions were submitted online in 2021.

Figure 6: Land Title Registry Revenue

The revenue from the land title registry was flat between 2018 and 2020 at around ~$50 million. However, with the increase in real estate activity in 2021, revenue increased to $63 million in 2021. As real estate activity in the country slows down, the revenue from the land registry sub-segment will likely decrease to pre-pandemic levels. ISC’s average revenue per transaction in the land registry segment was $74. You can read more about the fees charged by ISC for various transactions here.

ii. Personal property registry (12% of Registry Operations revenue)

The Personal Property Registry enables lenders as well as buyers of personal property, such as motor vehicles, to search for information such as security interests registered against an individual, business, or personal property used as collateral. General provincial economic drivers, including automotive sales, interest rates, and the strength of commercial activity in Saskatchewan, influence the revenue in the Personal Property Registry.

Customers for personal property registry include third-party providers to the financial industry, financial institutions, insurance companies, law firms, equipment and auto dealers, and auctioneers. Customers are charged flat fees per transaction and almost all searches are completed online.

Figure 7: Personal Property Revenue

During the last 5 years, revenue from personal property registry has largely been flat at around $10 to $11 million. This is due to variations in personal property transactions. At the same time, the average revenue per transaction has increased from $215 in 2017 to $246 in 2021. Going forward the revenue from personal property should be relatively flat.

iii. Corporate registry (13% of Registry Operations revenue)

The Saskatchewan Corporate Registry is a system for registering business corporations, non-profit corporations, co-operatives, sole proprietorships, partnerships, and business names. Every corporation must be registered in the Corporate Registry to maintain its legal status and carry on business within Saskatchewan.

ISC’s corporate registry customers include law firms, companies in the financial sector, accountants, and businesses such as non-profit and cooperative associations. Services are billed as flat fees for each transaction. ISC earns most of its fees in the Corporate Registry in relation to maintenance services provided to business entities that file annual returns or wish to make changes to their structure or profile. Almost all the transactions were completed online.

Figure 8: Corporate Registry Revenue

Similar to revenue from the personal property sub-segment, the corporate registry revenue during the last five years has been flat between $10 to $11 million. The average revenue per transaction is $31.

iv.  Property tax (6% of Registry Operations revenue)

On June 1, 2022, ISC completed the acquisition of Reamined which has an exclusive contract with the Province of Ontario to provide property tax management infrastructure and services.

Reamined has provided these services to the Province of Ontario for over 25 years and typically renewed up to five‐year agreements with the province. These services support critical applications of information used by municipalities to facilitate the determination of property taxes annually. The total revenue for each year of the agreement is determined at the time of renewal and is paid monthly by the Province of Ontario to Reamined.

Below we take a deeper look at the Reamined acquisition, the only acquisition done by ISC within the Registry Operations segment to date.

v.  Reamined Acquisition (2022)

Business Description

ISC completed the acquisition of Reamined on June 1, 2022. The acquisition led to the formation of the new Property Tax sub-segment under the Registry Operations Segment. As mentioned above, Reamined which has an exclusive contract with the Province of Ontario to provide property tax management infrastructure and services. The contract pricing increases as per CPI over the life of the contract.

Management’s Strategic Rationale on the Paragon acquisition

Acquisition pricing and financing

ISC has not disclosed the financials of Reamined. However, for the period June to September 2022, Reamined had revenue of $5 million. Accordingly, the extrapolated full-year revenue of Reamined is likely $15 million. ISC’s management has stated that Reamined’s margin profile is similar to the Registry Operations segment. Accordingly, assuming a 50% EBITDA margin, Reamined is expected to have an EBITDA of $7.5 million and an EV / EBITDA multiple of 6x for the acquisition.

Post acquisition performance

The sub-segment will likely only grow marginally based on CPI increases. Revenue is fixed under contract.

Fairway Research Remarks on Reamined

ISC has acquired a stable business that is related to its existing Registry Operations business. Even though Reamined is a slow-growth business, it will further boost the already strong cash flow profile of the Registry Operation segment due to high margins.

vi.  Registry Operations Segment Financial Performance

The Registry Operations segment is a high-margin low growth business. As discussed above, revenue largely depends on how the Saskatchewan economy does with real estate activity and car sales being the main drivers. The corporate registry business is more maintenance in nature. Between 2018 and 2020, revenue largely stayed flat at around $70 million.

Figure 9: Registry Operations Financial Performance (Including Corporate)

Figure 10: Registry Operations Segment Return on Assets (Including Corporate, before tax)

The Registry Operations segment is the cash flow engine of ISC. Given the low amount of assets required to run the business and high EBITDA margins, the segment also boosts of very attractive return on assets (EBITDA / Total Assets) of above 30%. ISC management has indicated that as real estate activity slows down, it expects Registry Operations EBITDA to trend toward pre-pandemic levels.

Note that I have loaded the entirety of corporate expenses, and corporate assets onto the Registry Operations segment, and still the segment have very impressive EBITDA margins and return on total assets ratio.

Figure 11: Typical Margin of Registry Operations (Excluding Corporate Expenses)

Note that excluding the Reamined acquisition, the segment has needed minimal capital expenditures. ISC overall has negative working capital.

2. Services Segment – Built through Acquisitions

Services Segment provides solutions to support registration, due diligence, and lending practices of customers across Canada. ISC’s Service Segment offerings are generally categorized into three divisions, namely Corporate Solutions, Regulatory Solutions, and Recovery Solutions. The Corporate and Regulatory solutions sub-segments were built up through two main acquisitions, ESC Corporate Services in 2015, and AVS Systems in 2017. The Recovery Solutions sub-segment was set up with the acquisition of Paragon in 2022. The table below sets out the various offerings provided by ISC’s Services segment. The main brand under which these services are provided is ‘ESC’.

Figure 12: Service Segment Offerings

Figure 13: Services Segment Revenue Breakdown

ISC has completed six acquisitions in the Services segment between 2015 and 2022, including ESC Corporation Services, AVS Systems, SecureFact Transaction Services, Paragon, and Uplevel. Figure 14 below includes a summary of all transactions completed in the Services Segment. We will now dive into the three main transactions in the Services segment, i.e., ESC Corporate Services, AVS Systems, and Paragon. Together these three transactions represented around 90% of the acquisition spending within the Services Segment.

Figure 14: Services Segment Acquisitions

i. ESC Corporate Services Acquisition (2015)

Business description

ISC first entered the services segment through the acquisition of ESC in 2015. This was ISC’s first venture into a vertical other than the legacy Registry Operations business. ESC provides law firms, corporations, financial services institutions, and others with services and online solutions to fulfill their clients' public records due diligence, filings, and corporate supply requirements in connection with public business registries in Canada and certain other countries. At the time of acquisition, ESC had over 4,500 clients, including law firms, corporations, and financial institutions. However, the top 20 customers contributed almost half the revenue of ESC. ESC Corporate Services Ltd. was formerly known as Corporate Search, Registration and Corporate Supplies division of Dye & Durham (TSX: DND).

The main revenue sources within ESC were search and registration (largest), know-you-customer (KYC), and corporate supplies.

The small acquisition of Alliance Online for $1 million in 2017 was a tuck-in acquisition for the ESC business. Alliance was a personal property corporate and land registry searches and submission provider.

Management’s Strategic Rationale on ESC acquisition

Acquisition pricing and financing

ESC was acquired for an enterprise value of $26.7 million. The acquisition was financed with $15 million of debt and included up to $7 million worth of contingent consideration (fair value $6 million). ESC had an EBITDA of $3.2 million in 2015 implying an EV / EBITDA multiple of 8.4x. At the time of the acquisition, ISC’s own traded EV/ EBITDA multiple was ~8.6x.

Post acquisition performance

In 2016, the first full year of ESC post-acquisition, it had revenue of $13.6 million (up 10% from 2015) and EBITDA of $2.7 million (down 15% from 2015). In 2017, the Services Segment achieved revenue of $14.9 million (up 10% from 2016) and EBITDA further decreased to $1.7 million.

Figure 15: Services Segment (essentially ESC) performance in 2016

Fairway Research Remarks on ESC Acquisition

Pros

The ESC acquisition was in a vertical with a similar client base as the existing Corporate Registries sub-segment of ISC. ESC did have lower EBITDA margins of 26% as compared to the ~40% EBITDA margin for ISS before the acquisition. The acquisition EV/ EBITDA multiple was in line with ISC own traded multiple. The transaction was financed through the use of debt; albeit the amount seemed conservative. The use of contingent consideration as a risk mitigation strategy was also a good M&A tactic.

Cons

The main downside seems to have been the disappointing EBITDA performance of ESC post-acquisition. It also seems the business had minimal synergies with ISC’s current business due to no geographic overlap.

ii. AVS Systems Acquisition (2017)

Business Description

AVS Systems was ISC’s second major acquisition in the Services Segment completed at the end of 2017. AVS provided automation software technology services to serve lending, leasing, and credit issuing businesses and institutions in Canada.

Management’s Strategic Rationale for AVS acquisition

Jeff Stusek, the former CEO of ISC, mentioned on a podcast episode that ISC’s bank customers requested them to be involved at the end of the credit cycle which eventually led to the acquisition of Paragon.

Acquisition pricing and financing

CAD$25 million was paid in cash on closing and ISC agreed to a max CAD$20 million in additional consideration contingent on the realization of future business with financial institutions and auto and equipment finance companies across Canada (fair valued at $15 million at the time of acquisition and eventually paid $11 million, making the enterprise value $35 million). The acquisition seems to have been financed entirely through internal cash.

Based on financials for the 9 months ended September 30, 2017, AVS Systems was estimated to have revenue of $22.6 million and EBITDA of $2.9 million. Accordingly, the acquisition EV/ EBITDA was 12.4x. Note that AVS Systems was growing at a high rate and had almost doubled its revenue between 2015 and 2016 and was expecting to keep growing at a high rate which might have also been the reason for the high contingent consideration. ISC’s own trading EV / EBITDA was ~10x at the time of the acquisition.

Post acquisition performance

Post-acquisition AVS became part of the Segment Services along with ESC and Alliance. AVS is estimated to have contributed revenue of $26.4 million to 2018 Service Segment revenue (17% revenue growth for AVS). The Services Segment overall had a 2018 revenue of $42 million and an EBITDA of $6.5 million. Representing an EBITDA margin of 15%, a reasonable improvement from the 11% margin witnessed in 2017.

Considering ISC paid $67 million for ESC (incl Alliance) and AVS together, $6.5 million EBITDA represents a post-acquisition EV / EBITDA multiple of 10.3x.

Fairway Research Remarks on AVS Systems Acquisition

Pros

The AVS Systems acquisition was in a vertical with a similar client base as the existing Personal Property Registries sub-segment of ISC.

The acquisition EV/ EBITDA multiple seemed high at the time of the acquisition at 12.4x. However, the 2018 performance of the Services Segment seemed to imply a lower EV / EBITDA multiple of 10.3x which was reasonable.

Cons

AVS was higher revenue low margin business and had an impact on ISC’s overall EBITDA profile.

iii. Paragon Acquisition (2020)

Business Description

On July 31, 2020, ISC completed the acquisition of Paragon which provides asset recovery services. This acquisition also led to the formation of a new sub-segment within the Services Segment named ‘Recovery Solutions’. Asset recovery involves the identification, retrieval, and disposal of movable assets such as automobiles, boats, aircraft, and other forms of portable physical assets used as collateral security for primarily consumer-focused credit transactions. Customers include most of the major banks that are involved in lending in the movable asset market in Canada. The business is counter-cyclical and can pick up if interest rates keep on rising.

Management’s Strategic Rationale on the Paragon acquisition

Acquisition pricing and financing

ISC acquired Paragon for $70 million making it the largest acquisition for ISC till date. The transaction was financed primarily through $60 million of debt. For the year ended March 2020, Paragon had revenue of $12.9 million and EBITDA of $7.7 million. The transaction EV / EBITDA was 9.1x. At the time of the transaction, ISC's own trading EV / EBITDA multiple was 9.9x.

Post acquisition performance

In 2021, the first full year post the Paragon acquisition, the recovery solutions revenue was $9.5 million, which was lower than the $12 million pre-acquisition revenue. Management primarily attributed this to Covid related government support. For the LTM period, Recovery Solutions’ revenue remained flat at $9.8 million.

Fairway Research Remarks on Paragon

Pros

High EBITDA margin (60%) business. In a way, the Paragon business is a natural hedge to the land registry business of ISC which may face challenges is the economy slows down. Customers of Paragon are big banks, which already dealt with ISC through the Services Segment.

Cons

The business is also yet to reach the revenue levels that it witnessed prior to the pandemic.

iv.               Services Segment Financial Performance

As discussed earlier, the Services Segment has grown through acquisitions. The Services Segments had an EBITDA margin of 23% in 2021 and 21% in the LTM period. This was less than half the EBITDA margin enjoyed by the Registry Operations Segment even with corporate expenses fully loaded onto the Registry Operations segment. If we allocate a portion of corporate expenses to the Service Segment, the EBITDA margins will be lower.

Figure 16: Services Segment Performance

Figure 17: Services Segment Return on Assets (before tax)

Figure 18: Registry Operations Segment Vs Services Segment Vs. Consolidated Return on Assets (before tax)

As can be clearly seen from Figure 18, the businesses being acquired within the Services Segment are clearly not as superior in terms of returns on assets as the Registry Operations segment. The Registry Operations business, even though low growth, is a monopoly business with an exclusive MSA with the provincial government. A comparable competitive advantage is difficult to replicate in acquired businesses. The Registry Operations segment is really the cash flow engine enabling the expansion of ISC into other businesses.

3. Technology Solutions Segment (ERS Acquisition, 2017)

The technology solutions segment was formed with the acquisition of Enterprise Registry Solutions in 2017. It is the smallest segment in ISC that contributes about 4% of total revenue ($7.4 million). The Segment makes revenue through:

·         Sale of software licenses related to the technology platform;

·         Provision of technology solution definition and implementation services;

·         Provision of monthly hosting, support, and maintenance services.

These services are provided under the ‘ERS’ brand. The Segment has a software offering called RegSys that provides a readily transferable technology platform capable of registry needs. The Segment provides services to both internal clients, and external parties (mainly government clients). 52% of its revenue came from internal parties and 48% from external parties. The internal use of ERS was one of the rationales for the acquisition, as previously ISC was ERS’s customer.

“Saskatchewan Corporate Registry is built on the RegSys platform. And now that we have that technology and that expertise in-house, we're also looking at how that will apply across some of our other registries” – August 2017, Conference Call

Technology Solutions’ overall performance has been sub-par with revenue declining in 2020 and 2021. The management has attributed this to Covid-related slow-down project spending while governments were prioritizing healthcare spending.

Figure 19: Technology Solutions Financial Performance

The ERS acquisition was completed in 2017 at an enterprise value of $13.4 million. Financed through internal cash, the acquisition contributed EBITDA of 0.5 million to ISC’s 2017 financials. Accordingly, the transaction was completed at an EBITDA multiple of 25x. A significant premium as compared to other acquisitions completed by ISC. However, since almost half the revenue of Technology Solutions comes from other Segments with ISC, it likely internalized some of the EBITDA which was contributed by ISC as a customer.

F. Acquisition Summary

G. ISC’s Historical Financial Performance

Figure 20: ISC Historical Financial Performance

1. Revenue growth

We have discussed the various drivers of segment revenue growth in Section C. Here we will discuss ISC’s consolidated revenue growth over the last 5 years. Between 2017 and 2021, ISC’s overall revenue grew at a CAGR of 13%.

ISC’s legacy Registry Operations segment only grew at a CAGR of 3%, from $74.9 million in 2017 to $85.6 million in 2021.

The Service Segment revenue grew at a CAGR of 38%, from $14.9 million in 2017 to $75.2 million in 2021. This has led to it becoming almost as big as the Registry Operations segment in terms of revenue contribution. In fact, during the LTM period, both Registry Operations and Services Segment contributed 48% each to the total revenue of ISC.

Technology Solutions is the smallest segment in ISC and grew from $3.7 million in 2017 to $8.6 million in 2021 at a CAGR of 18%.

For more details on the growth of individual segments refer to Section D.

Figure 21: ISC Revenue Composition

2. Operating Expenses

i. Wages and Salaries

ISC’s biggest operating expense is the wages and salaries of its 400 employees. It is evident that ISC’s management has kept the wages and salaries cost in check while growing the company at a healthy rate. Between 2017 and LTM, ISC’s revenue doubled from $93.6 million to $188.0 million. However, the wages and salaries cost only grew from $33 million (35% of revenue) to $48 million (25% of revenue).

Approximately 28 per cent of ISC’s employees are unionized under the Saskatchewan Government and General Employees’ Union.

Figure 22: ISC Wages and Salaries Cost

ii. COGS

The COGS expense of ISC relates to the provision of government-related services and has been increasing in line with revenue. The COGS increased substantially in 2018 with the acquisition of AVS Systems. For the period 2018 to 2021 COGS averaged about 23% of revenue.

iii. Other expenses

The other main expenses of ISC include IT costs and occupancy costs. Both of which have been trending downward while the company has been growing. IT costs are down from 12% of revenue in 2017 to 5% in the LTM period. Occupancy costs are down from 6% of revenue in 2017 to 2% in 2021 (partly driven by IFRS-16 accounting change). The management of ISC deserves full credit for excellent cost management. Even with multiple acquisitions and a difficult inflationary environment, management has run a tight ship in terms of hiring and expenses.

3. EBITDA

ISC’s reported EBITDA increased from $30.0 million in 2017 to $67.7 for the LTM period. Reported EBITDA margin was 32% in 2017 and 36% in the LTM period. While EBITDA seems to be increasing in line with revenue, it is important to understand the source of the increase in EBITDA. The Registry Operations segment makes up the majority of ISC’s EBITDA even though the contribution has decreased from 93% in 2017 to 71% during the LTM period. While the Registry Operations segment’s contribution to revenue is down to 48%, it still contributed more than 70% to the reported EBITDA of ISC (even with corporate expenses fully allocated to Registry Operations) in the LTM period.

Figure 23: ISC EBITDA Composition

ISC’s adjusted EBITDA, which includes a deduction for share-based compensation and an IFRS adjustment for cash lease cost, increased from $32.0 million in 2017 to $67.0 for the LTM period. Adjusted EBITDA margin was 34% in 2017 and 36% in the LTM period.

4. Working Capital and Capital Expenditures

ISC has always maintained negative debt-free cash-free working capital. The business model does not generally require a high level of accounts receivables. The business also required minimal maintenance capital expenditures on PP&E and intangibles which have ranged between 1% to 2% of revenue over the last 5 years.

5. Return on Invested Capital

ISC’s return on invested capital has been impressively over 30% in the last 5 years. Although these returns are largely driven by the legacy Registry Operations business.

Figure 24: ISC Return on Invested Capital

Return on Invested Capital = Free cash flow / Average Invested Capital

Invested Capital = PP&E + Net Working Capital + Intangible Assets + Goodwill + ROU Assets

H. Management

Shawn Peters, CEO

Shawn Peters joined ISC in 2012 as Vice President, Finance & Technology and Chief Financial Officer and was appointed President & Chief Executive Officer in 2022. He had been the CFO of ISC since its IPO and was involved in the acquisitions completed by ISC since 2015. Prior to ISC, he spent several years with Group Medical Services, where he served as Senior Vice-President and Chief Financial Officer. Mr. Peters holds a Bachelor of Commerce from the University of Saskatchewan and a Chartered Professional Accountant designation.

You can read about other members of the ISC management here.

1. Capital Allocation

No external equity issuance and buybacks

The company has not issued any equity to external investors since the IPO. The company has also not conducted any buybacks since being listed. However, given the current attractive valuation levels at which ISC trades, I hope the management considers doing buybacks in the near future (See section on Valuation).

Conservative use of debt for acquisitions

The company has also been very conservative with the use of debt, only using it for acquisitions. Even with the recent debt increase with the relatively larger acquisitions of Paragon and Reamined, the debt level as of September 30, 2022, is only at 1.1x LTM EBITDA.

Figure 25: 5-year Capital Allocation Summary

Two main uses of capital – Dividends and Acquisitions

Between 2017 and 2021, ISC has mainly allocated capital towards two main uses, dividends, and acquisitions. Of the $212.5 million of cash inflow generated by the company, $125 million (59%) was allocated toward acquisitions. Another $70 million (33%) was allocated toward dividends.

Note that ISC inherited a high dividend from its time of being a crown corporation. To the credit of ISC’s management, it has not reduced the dividend amount but by increasing the overall free cash flow, decreased the payout ratio from 60-70% of FCFF before 2016 to 30% in the LTM period. The management increased dividends for the first time since its IPO in 2021 by 15%.

Figure 26: ISC Dividend Payout Ratio (Dividend / FCFF)

I discussed ISC’s capital allocation towards acquisitions in more detail in Section D. However, it might be good to summarize its acquisition here as well.

Figure 27: ISC Acquisitions

Have acquisitions created value?

Taking all acquisitions, other than Reamined Systems, ISC has spent close to $165 million on acquisitions in the Services Segment and Technology Solutions. The combined EBITDA of the Services and Technology Solutions segments for the LTM period was $20 million. That translates to a return on capital of 12%. Note that 12% is before taxes and any allocated of corporate expenses which would bring the return further down. While most acquisitions done by ISC made sense on paper, the returns from acquisitions for ISC have been average at best.

2. Cost Management

As mentioned before, ISC’s management has done a commendable job at cost management. While amid seven integrations and a challenging inflationary environment, the management has kept wages in check, and other costs such as IT and occupancy have been decreasing as a percentage of revenue.

Figure 28: ISC Costs as % of Revenue

3. Performance Guidance

ISC’s management guidance has been conservative in the past. Out of the 4 years when they have issued guidance, only once they have revised it downward, and that too not by a big margin.

Figure 29: ISC Management Guidance Vs. Actual

4.               Ownership and Compensation

In addition to the base salary, the ISC executives are entitled to short-term incentive compensation which is 60% based on corporate performance goals and 40% on individual performance.

The corporate performance measures are based on the following:

I think corporate performance measures around EBITDA and free cash flow make management better aligned with shareholders than measures such as revenue.

Figure 30: Compensation Table

Note that Jeff Stusek is the ex-CEO of ISC who retired in early 2022.

Shawn Peters currently only holds 10,000 shares of ISC. However, he has unexercised options on close to 331K shares, making his fully diluted ownership close to 2% of ISC.

5. Culture

As per Glassdoor, the ratings for ESC and ERS are much better than ISC. However, the tenure of employees (as per LinkedIn) at ISC is higher as compared to ESC and ERS. 28% of ISC’s employees are unionized.

I. Shareholding and Role of Government

Other major shareholders of ISC as of March 2023 are as follows:

Figure 31: Major Shareholders

Golden Share

The Crown Investments Corporation of Saskatchewan also holds one ‘Golden Share’ of ISC. The Golden Share has certain voting rights and obligations including regarding the location of the head office and the sale of certain of the assets of the Company. It receives no dividend. The Golden Share gives veto power to the Saskatchewan government in relation to:

• a transfer of the Company’s registered office outside of Saskatchewan;

• a transfer of all or any part of the Company’s head office operations, outside of Saskatchewan;

• the sale, lease, or exchange of all or substantially all of the Company’s property;

J. Valuation

To compute the intrinsic value of ISC, I use a discounted cash flow model. Based on a 10% discount rate and a 2% long-term growth rate, the estimated intrinsic value of ISC is around $29 per share, which represents an upside of 30% from the current market price of $22.6 (as of March 10, 2023).

The intrinsic value estimate is based on the average of two scenarios of discounted cash flow. In the first scenario, ISC only grows organically without acquisitions and at a very conservative rate. In the second scenario, ISC spends $20 million annually on acquisitions for the next 5 years. (See Section M)

Figure 32: Intrinsic Value Estimate (March 10, 2023)

Key Assumptions:

No acquisitions scenario:

• Revenue grows at an organic CAGR of 4% from $188 million in the LTM period to $225 million in 2027.

• EBITDA margin decreases from 35.6% in the LTM period to 31% in 2027 as the Services Segment grows to become a bigger percentage of ISC’s revenue.

• Maintenance capital expenditures of 1% to 1.5% of revenue

• Working capital levels gradually increase to 1% of revenue.

Additional assumptions in Acquisition Scenario:

• $20 million spent on acquisitions each year

• Companies acquired at an average EV / EBITDA multiple of 8x.

• Target companies have EBITDA margins of 25%

• With acquisitions, ISC’s revenue grows from $188 million in the LTM period to $275 million in 2027

• EBITDA margin decreases to 30% in 2027 as acquisitions have lower margins than Registry Operations

Figure 33: Historical Valuation Levels (EV / EBITDA)

The current valuation levels are also one of the most attractive (read lowest) in terms of EV / EBITDA multiple since ISC went listed in 2013. My intrinsic value estimate of $29 implies an EV / EBITDA multiple of 8.4x, as compared to the currently traded multiple of 6.6x.

K. Risks

Saskatchewan MSA Renewal in 2033

One major risk is whether the 20-year MSA for registry services will be renewed in 2033. I think the risk will always be there, however, it is mitigation to an extent by the fact that Saskatchewan Government still holds a 30% equity interest in ISC and the golden share.

Customer Concentration

There is a small customer concentration in Registry Operations and Services Segment. Risk is mitigated in Registry Operations because ISC is the only provider. In Services Segment, the risk is higher as ISC has higher competition.

L. Conclusion

I believe ISC is a stable business with strong cash flow generation and is priced attractively. The Saskatchewan Registry Operations business is a monopoly business with high margins and requires minimal reinvestment. Management has a track record of multiple acquisitions since the IPO and has maintained quarterly dividends since the IPO. With an intrinsic value estimate of $29 per share, ISC presents a 30% upside opportunity.

Detailed discounted cash flow models are in the PDF linked at the beginning of the article.

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Thanks for being a subscriber to Fairway Research! Today we take a deep dive into TerraVest Industries, a Canadian consolidator of manufacturing business operating in niche markets. This seemingly boring business is one of the best compounders of wealth in the Canadian markets over the last 10 years. We dig into the business, acquisition strategy, financials, management and valuation. With no investor relations or analyst coverage, this report was a challenging one to write. I hope you like the effort. Below is a Google Drive link to a downloadable PDF of the report (which I firmly believe is a better way to read this long report - get your iPad and coffee and dig in). To give you a sense of the work that has gone into the report, and also give you the flexibility to play around with valuation assumptions, I’ve made my financial model downloadable below.

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Summary:

• TerraVest Industries Inc. (TSX: TVK) is a Canada based serial acquirer of manufacturing business. It is often the top three player within the niche markets it operates in.

• Over the past decade, TerraVest has created tremendous wealth for its shareholders through superior capital allocation. $100 invested in TerraVest as of September 30, 2017, turned into $286 as of September 30, 2022, at an annual return of just over 23% (as compared to $137 for the TSX Composite Index at a rate of 6.5%).

• TerraVest does not have an active investor relations function and has no analyst coverage. Supplementary information such as company presentations are also hard to find. Thus, the broader investing community has largely overlooked the company.

• TerraVest divides its business into three operating segments. The largest segment is Fuel Containment which it contributes 57% of total revenue and is not dependent on oil and gas activity. The other two segments, Processing Equipment (28% of revenue) and Services (16% of revenue) are dependent on oil and gas activity.

• Between FY2014 and FY2022 TerraVest acquired 14 companies by paying low single digit EBITDA multiples for its acquisitions. These are generally niche manufacturing business which either have no succession plan or are in distress. By paying reasonable acquisition prices and through the realization of post-acquisition synergies, TerraVest can generally achieve returns of investment of ~17% on its acquisitions. It further boosts returns by financing these acquisitions through debt.

• TerraVest’s revenue has grown from $270 million in FY2018 to $577 million in FY2022 at a CAGR of 21%. Even with the challenges posed by the pandemic, TerraVest was able to maintain average EBITDA margins of ~14%. Further, despite being an asset heavy business, TerraVest has maintained returns on invested capital ranging between 14% and 17%.

• TerraVest’s management has a great capital allocation track record. In addition to opportunistically acquiring niche businesses, the management has returned significant amount of capital to shareholders in form of share buybacks.

• My discounted cash flow model indicates that TerraVest’s current share price is close to the intrinsic value of its current business (“As-Is” TerraVest). This means that the market is ascribing no value to growth through future acquisitions and the commendable capital allocation record of TerraVest’s management.

• Based on the above, I conclude that there is significant upside potential in TerraVest’s stock for the long-term shareholder.

Disclaimer: Fairway Research is currently long TerraVest shares. This report is only for educational purposes and is not meant to be investment advice. Readers should do their own due diligence before investing.

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A.  Introduction

TerraVest Industries (“TerraVest”) is a diversified manufacturer and consolidator of sophisticated steel and related products such as tanks for storage of heating oil, containers for transport for compressed gases and well head equipment. The company also provides certain specialised services to the oil and gas industry. TerraVest is often the #1 or #2 player in a niche infrastructure market.

Because of the niche characteristics of the industries TerraVest operates in, it can acquire smaller companies at reasonable valuations and roll them up into the TerraVest umbrella of brands. TerraVest is a case study of a disciplined acquisition strategy coupled with good capital allocation leading to consistent increase in shareholder value.

TerraVest had last twelve-month (“LTM”) revenues of $623 million as of December 2022. As of February 17, 2023, TerraVest had a market capitalisation of $478 million and an enterprise value of $700 million. All figures in this report are Canadian dollars unless otherwise stated.

Note that TerraVest is not an exciting business by any means and while I was stretching my circle of competence at times, I have tried to break down the business in a structured format. Unfortunately, the company has no investor relations website. Hardly any investor presentations. No analyst coverage or conference call transcripts. Disclosures in the annual financials also tend to be limited. This is often cited as one of the reasons that TerraVest is not widely known in investing circles even after generated tremendous wealth for its shareholders. TerraVest is often featured in most ‘consistent compounder’ lists of Canadian stocks. Let us dig into this M&A Machine.

B.  Brief history of TerraVest

The current TerraVest is vastly different from the company it was 10 years back. Starting in 2011, the company divested several underperforming businesses, and beginning in 2013, TerraVest started acquiring companies which had presence in niche industrial manufacturing sectors. Clarke Inc., which first invested in TerraVest in 2007, was the main activist shareholder during the turnaround period, and the investment faired very well for them with an IRR of 18% and a total return of 254% over its holding period up to 2019. As per Clarke Inc., prior to its involvement, TerraVest was a “broken income trust with a disparate collection of underperforming portfolio companies”. TerraVest reduced its exposure to the oil and gas industry by acquiring niche manufacturers in sectors unaffected by oil and gas cyclicality. TerraVest currently operates through a network of 24 subsidiary companies and has over 1650 employees. Its operations are primarily based in Canada and the U.S.

C.  Understanding TerraVest’s business

TerraVest’s business is divided into three main operating segments as highlighted in Figure 2 below. The largest segment is Fuel Containment, it contributes 57% of total revenue and is not dependent on oil and gas activity. The other two segments, Processing Equipment (28% of revenue) and Services (16% of revenue) are dependent on oil and gas activity. In Q1 FY2023 TerraVest replaced the Fuel Containment segment with HVAC Equipment and Compressed Gas Equipment segments.

1.    Fuel Containment Segment

The fuel containment segment is the largest segment within TerraVest. The segment is:

#1 manufacturer of home heating oil products in North America.

#1 manufacturer of propane, anhydrous ammonia (“NH3”) and natural gas liquids (“NGL”) transport vehicles and storage vessels in Canada and top two in the U.S.

TerraVest’s fuel containment segment operates through a network of six warehouses and 10 manufacturing facilities spread across Eastern Canada and the U.S. The segment has 933 employees of which 232 are unionized.

The fuel containment segment has two main sub-segments, which are, the HVAC equipment sub-segment and the Compressed Gas Equipment sub-segment.

1A. HVAC Equipment Sub Segment

TerraVest’s HVAC equipment sub-segment includes products such as home heating oil tanks, furnaces, and commercial fuel tanks. It is a critical supplier to the heating oil markets in North America.

Certain areas in Canada, in particular remote communities in the Canadian territories and rural areas across the provinces, do not have direct access to infrastructure that would enable home heating, such as an electrical grid or pipeline network. This means, they can only use heating sources that can be delivered without any “hard” tie ins to their home – making petroleum fuels like heating oil, diesel, and propane absolutely essential. Natural Resources Canada estimates that nearly three quarters of our 250 remote communities use heating oil or propane for home heating.

Prince Edward Island is the top region by household heating oil consumption in Canada. As of 2019, household heating oil consumption in Prince Edward Island accounted for 20% of Canada's household heating oil consumption. Along with 4 other regions (Ontario, Nova Scotia, Newfoundland and Labrador, and New Brunswick) it accounted for 86% of total heating oil consumption in Canada.

TerraVest’s facilities are strategically located in the eastern Canada which is, as mentioned above, the largest heating oil consumption market. The main brand under which TerraVest sells heating oil tanks and related products is ‘Granby’.

In FY2021 TerraVest further expanded its HVAC Equipment sub-segment by acquiring ECR International, which sells its products under a family of eight well established brand names, including the Dunkirk and Utica boiler brands, and has a 10%+ market share in the North American residential boiler market.

1B. Compressed Gas Equipment Subsegment

TerraVest is the only manufacturer of LPG / NH3 / NGL storage and transport equipment with a national footprint in Canada.

TerraVest’s has 3 main brands which manufacture large propane containment vessels (pro par), assemble propane transport trucks (Signature Truck) and refurbish domestic tanks (Fischer Tanks). To get further colour on TerraVest’s Compressed Gas Equipment Segment watch this video:

Fuel Containment Segment Performance

The Fuel Containment segment of TerraVest has grown from $143 million in revenue in FY2018 to $328 million in FY2022 at a compounded annual growth rate (“CAGR”) of 23%. The growth has been fueled primarily by two big acquisitions, that is, Mississippi Tank and Manufacturing Company in FY2022 and ECR International Inc. near the end of FY2021. Accordingly, there was significant jump in Fuel Containment revenue in FY2022 as can be seen in Figure 3. These two acquisitions and the rise in global steel prices had a meaningful impact on the EBITDA margin of segment which decreased from 26% in FY2021 to 17% in FY2022. However, since TerraVest will likely realise synergies from these acquisitions going forward this margin can improve. Note that based on the limited information disclosed in Q1 FY2023, the HVAC Equipment Subsegment has higher EBITDA margins than Compressed Gas Equipment Subsegment.

2.    Processing Equipment Segment

The processing equipment segment is the second largest segment within TerraVest.

TerraVest is the #1 player in wellhead processing equipment in Canada and is a critical supplier to large oil and gas producers in North America.

The Processing Equipment segment manufactures and sells equipment such as: wellhead processing equipment and tanks, wellhead de-sanding units, central facilities processing equipment, natural gas liquids (“NGL”) and LPG storage tanks, anhydrous ammonia storage tanks. The segment markets its products to oil and gas producers, midstream companies, engineering companies, propane distributors, fertilizer distributors and transportation companies. TerraVest sells the products in this segment under the Maxfield, Argo, NWP, Segretech and Environvault brands.

The segment conducts operations through seven subsidiaries with nine manufacturing facilities which are primarily located in Alberta and one facility located in Iowa. The segment has 423 employees out of which 49 are unionized.

Processing Equipment Segment Performance

The revenue of the processing segment has been volatile over the past 5 years. Even after acquiring two new companies during FY2019 and FY2020, the revenue of the segment fell in FY2021. This was primarily attributable to a 43% decrease in organic revenue during FY2020 due to weak energy processing equipment demand. The demand was primarily impacted by Covid-19 and weaker commodity pricing. The future performance of Processing Equipment segment will also vary with the capex cycle of oil & gas players. The forecast of oil and gas capex in Alberta is expected to be relatively flat up to FY2031. However, TerraVest might be looking to opportunistically acquire companies to further expand market share.

3.    Services Segment

The services segment is the smallest segment within TerraVest. It provides energy producers within Western Canada with services such as fluid hauling, water management, environmental solutions, heating, rentals and well servicing. Green Energy Services and Fraction Energy Services are the main brands under this segment. The segment also has 21 oil and gas service rigs which generate revenue based on utilization and are provided under the brand name of Diamond Energy Services. The demand for the services segment is also tied to oil and gas production. The segment has 297 employees.

The segment provides its services through two subsidiaries, which is Diamond Energy Services and Green Energy Service. These subsidiaries have a network of six field offices and two operating facilities. The service rigs are located in Saskatchewan (Diamond Energy Services) and other field offices are located in Alberta and Fort St. John, British Columbia (Green Energy Services).

We estimate that, post the acquisition of Green Energy Services, about 80% of revenue from this segment comes from fluid hauling, water management, rentals and environmental solutions. The remaining 20% revenue comes from the service rigs. The performance of the segment primary depends on oil and gas activity in Western Canada which is dependent on oil and gas prices.

The demand for service rigs is generally different than for drilling rigs and is not as directly impacted by the price of oil or gas. Work on existing wells can be more economical when commodity prices are lower because operating costs are not as high, and returns are often more predictable. This means service rigs (operated by Diamond Energy Services) may still be busy when producers aren't otherwise looking to drill new wells. The Canadian Association of Energy Contractors estimates that active rig count in Canada will increase by 15% in 2023 as compared to 2022.

The acquisition of majority stake in Green Energy Services (estimated revenue of ~$75 million) in FY2022 increased the revenue of the service segment from sub $20 million per year to $90 million. Note that, there is small customer concentration risk in the Services Segment as two major customers account for 12% and 11% of revenue.

D.  Acquisition Strategy

TerraVest is a serial acquirer and consolidator of smaller companies operating in niche manufacturing markets. Between FY2014 and FY2022 TerraVest acquired 14 companies. Seven of these acquisitions were in Fuel Containment Segment. Five in the Processing Equipment segment and two in Services. We discuss different aspects of TerraVest’s acquisition strategy such as pricing discipline, synergy potential, and financing. Specifically:

• TerraVest opportunistically acquires company which don’t have a succession plan in place or are in distress.

• TerraVest has been very disciplined in paying around 0.4x to 0.6x revenue multiples for its acquisitions. This allows TerraVest to achieve higher returns on acquisition price post synergies. Synergies mostly relate to procurement and corporate expenses.

Lastly, to augment the returns from acquisitions TerraVest mostly finances them through further debt issuances.

Pricing Discipline

TerraVest has spent over $230 million on acquisitions in the last 9 years with a median deal size of $15 million. It has paid median EV / Revenue multiple of 0.6x revenue. The highest revenue multiple it paid was 1.1x (Fischer Tanks). The EV / Revenue multiples do tend to be slightly higher for larger acquisitions (See Figure 9 below).

While the company does not disclose the financials of the acquired firms (else than the first 3 acquisitions), if we assume a 15% EBITDA margin for the acquired companies, the median implied EV / EBITDA paid by TerraVest is 4.2x. If we conservatively assume a 10% EBITDA margin instead of 15%, the median multiple increases to 4.8x which is also reasonable. Based on this impressive history we can conclude that TerraVest’s management has been extremely disciplined with prices it is willing to pay for targets. This is especially impressive given that it faces competition from middle market PE firms for deals. In such industries is it much easier to acquire companies for reasonable valuation rather than spending capex and time to build the infrastructure and customer relationships. Another reason why these companies are relatively cheap, are because they operate in low growth vertical markets with limited standalone opportunities to expand. However, once the companies are under the TerraVest umbrella, a host of possibilities for cost saving and cross-selling products opens.

TerraVest’s pricing discipline can be attributed to high internal hurdle rates for acquisitions. Hurdle rates are required rates of return from acquisitions. To understand hurdle rates, let’s back calculate the returns which TerraVest can make by paying such low multiples for acquisitions. Assume, TerraVest acquires a company for $50 million (including debt). It pays 0.6x revenue multiple and the target company has 15% EBITDA margins post acquisition. Let us also assume 2% of revenue as maintenance capex. This would give us net operating profit after tax (“NOPAT”) of ~$10 million. So, a return on acquisition price of 17% ($10 NOPAT / $50 Acquisition Price). Note that the 17% ROIC is in line with TerraVest’s own ROIC during the last 5 years. If we conservatively assume 10% EBITDA margins, the return on acquisition price would fall to 11%.

Opportunistic Acquisitions

Over the years, TerraVest’s has made certain smart acquisitions. One example is the recent acquisition of Platinum Energy Services where it paid ~$5 million for the acquisition. However, the business had significant carry forward losses, valued at close to $11 million, which could be set off with TerraVest’s own taxable income to effectively lower the cash taxes of TerraVest. The acquisition would pay for itself within the first year. Another example is its tuck in acquisition of EnviroVault in FY2016 where it bought the company assets under bankruptcy proceedings for only $1 million and is today one of the main brands in the Processing Equipment Segment.

Synergy Potential

It is important to emphasize that TerraVest gets day-1 synergies from acquired companies in terms of cost functions such as admin, accounting & finance, HR, IT systems, sourcing, and other head office costs by centrally managing these functions. For example, multiple TerraVest subsidiaries in the Processing Equipment Segment share a single sales and corporate office location in Calgary, Alberta. Further, TerraVest is also likely able to source its raw materials such as steel at more favourable rates as compared to smaller manufacturers. TerraVest posts the inventory of its different businesses on its online inventory platform where customers can see which products are currently available. This potentially leads to cross-selling opportunities across TerraVest’s businesses. Lastly, smaller firms do not have the resources to invest in automation of operations and hence miss out on cost savings. However, once the company is under TerraVest’s umbrella it can quickly automate operations. Note that TerraVest has spent close to $45 million on growth capex over the last 5 years (See Figure 24).

Acquisition Financing

TerraVest seems to be financing its acquisitions primarily through debt. This is evident from the significant increase in both acquisition spending and total debt over FY2021 and FY2022. Because TerraVest can service these debt levels at the consolidated level, it can further increase returns from acquisitions by financing them primarily through debt. Of course, this increases the risk as well but cautious use to debt to buy cash flow positive companies is a good strategy if executed well. Note that while the recent increase in debt level might appear concerning, TerraVest’s current Net Debt to EBITDA of 2.5x is significantly lower as compared to the levels of 3.7x seen at the end of FY2021.

E.  Historical financial performance

Revenue

TerraVest’s revenue has grown from $270 million in FY2018 to $577 million in FY2022 at a CAGR of 21%. However, since TerraVest is a serial acquirer, it is important to understand the bifurcation between organic and inorganic revenue growth during this period. Between FY2018 to FY2022, TerraVest made seven acquisitions. As shown in Figure 15 below, majority of TerraVest’s historical revenue growth is attributable acquisitions. Apart from FY2018 and FY2022, organic growth has been flat or negative.

The organic growth for the Fuel Containment Segment has been positive for the last three years. However, the Processing Equipment segment saw significant negative organic growth in FY2020 and FY2021 offsetting the growth of the larger Fuel Containment Segment.

As discussed earlier, the revenue from the Fuel Containment is independent from oil and gas. However, it is sensitive to winter weather and commodity pricing for propane and heating oil. The Processing Equipment revenue is dependent on oil & gas capital expenditure cycles and Services segment revenue depends on oil & gas drilling activity. The general oil & gas capex and opex levels are in effect dependent on oil pricing.

Geographically, slightly more than half the revenue of TerraVest’s revenue comes from Canada and remaining revenue comes from the U.S.

Gross Profits

The cost of goods sold (“COGS”) of TerraVest includes 3 main items, i.e., material costs, personnel expenses, and depreciation. Personnel costs and depreciation comprise about 30% of COGS and the remaining 70% are estimated to be material procurement and other ancillary conversion costs.

TerraVest’s gross profit margins improved from 22.8% in FY2018 to 26.2% in FY2021. However, it fell to 21.6% in FY2022 due to almost 60-80% increase in global steel prices. Steel prices have normalised since then. This is evidenced from the improvement in gross margins for the LTM December 2022 period as compared to FY2022 margins.

Further, note that TerraVest had acquired three large companies towards the end of FY2021 and in FY2022. Accordingly, once TerraVest is able to centralise procurement and get scale benefits in pricing, this gross profit margin might further improve. However, going forward gross profit margins will remain sensitive to global steel pricing cycles.

EBITDA Margins

Administrative and selling costs are the main operating expenses for TerraVest.

Administrative costs have on average been 9.5% of revenue and have grown at the same CAGR (20%) as revenue during FY2018 to FY2022. About half of the administrative costs are comprised of personnel related expenses.

Selling costs have on average been 2.3% of revenue. However, the costs increased to 3.2% of revenue in FY2022 primarily due to increase in personnel expenses within selling. Almost 80% of selling costs are comprised of personnel related expenses.

TerraVest average EBITDA margin over FY2018 to FY2022 have been ~14%. EBITDA margins during the LTM period improved to 14.1%.

Capital Expenditures

TerraVest’s maintenance capex requirements are quite minimal and have on average been 1.5% of revenue. TerraVest also spent ~$45 million over FY2018 to FY2022 on organic growth initiatives.

Working Capital

TerraVest’s business does require significant levels of working capital, usually more than 30% of revenues. Working capital as a % of revenue increased from 30% in FY2020 to 46% in FY2021. While, working capital levels have normalised to an extent by December 2022 (32% of revenue), I understand that the increased working capital as % of revenue in FY2021 was due to two reasons:

1. Closing of ECR International acquisition in August 2021. This transaction within the Fuel Containment segment was significantly large (~$100 million in revenue) and the FY2021 income statement did not fully reflect the impact of acquisition. However, the balance sheet included all the working capital of ECR International. So to think in terms of Working Capital / Revenue ratio, the numerator fully increased, while the increase in the denominator was muted. The lead to increase in the ratio.

2. General increase in steel prices which would have increased costs of inventory. As discussed earlier, steel prices have normalised as of December 2022.

Unless TerraVest makes significant acquisitions in the near future, the working capital levels seem to have stabilised.

Return on Invested Capital

During FY2019 to FY2022, TerraVest’s returns on average invested capital, as calculated based on stable unlevered free cash flow have ranged between 14% and 17%. Figure 18 below shows where TerraVest would be placed within the Russel 3000 index which cover 96% of the U.S. equity market.

E.  Management performance

Before discussing the specifics of the TerraVest’s management, let us dive into two key factors of determining management performance. These are, TerraVest’s capital allocation over the last 5 years and its share price performance relative to the TSX over the same period. In terms of capital allocation, we will discuss how the management has invested cash flows into the business, returned capital to shareholders, and acquired companies.

Capital Allocation

Figure 19 below includes a detailed breakdown of TerraVest’s capital inflows and outflows over the 5-year period between FY2018 to FY2022. TerraVest’s operations generated cash flow of $225 million. Of this $139 million was reinvested into the business in form of working capital and capex. TerraVest spent another $129 million on acquisitions and investments. $61 million was used to repay debt and $79 million was return to shareholders in form of dividends and share buybacks. The acquisitions specifically make sense because TerraVest can redeploy capital into the business at return on invested capital over 15% (See Figure 14). The deficit in cash flow was funded through raising additional debt of $198 million. As discussed earlier, the increase in debt is primarily to fund acquisitions. If we consider the net increase in debt of $137 million ($198 million – $61 million), it is close to the amount spent on acquisitions ($129 million).

Share Buybacks

TerraVest’s diluted share count has decreased from 20.6 million as of September 2018 to 18.4 million as of September 2022. During the period, TerraVest bought back 3.2 million shares at an average buyback price of $13.2 per share. This is almost half of the current share price of $26.42 (February 17, 2023). It is evident that TerraVest’s buyback programs have created substantial value for its shareholders over time.

Share Price Performance

$100 invested in TerraVest on September 30, 2017, turned into $286 as of September 30, 2022, at a CAGR of 23.4%. While the TSX Composite Index returned only 6.5% over the same period (turning to $137).

Key Management and Governance Team

Charles Pellerin – Chairman

Mr. Pellerin currently owns ~20% of TerraVest. He is the Principal Partner and President of one of the largest independent accounting firms in Quebec, Pellerin Potvin Gagnon S.E.N.C.R.L. Since 2009, Charles has been a board member of Clarke Inc. (TSX: CKI). In addition, he has been the Executive Chairman of TerraVest since 2014, when TerraVest acquired one of Charles’s manufacturing companies (Granby Industries).

Mr. Pellerin holds a bachelor’s degree in accounting from Ottawa University and a post graduate diploma in accounting from University of Trois-Rivieres, Quebec. He has been a member of the Quebec Order of the Chartered Accountants since 2000.

Dr Dustin Haw - CEO

Dr Haw took over as the President and CEO of TerraVest in 2017. Earlier, he served as a director on the board of directors since 2014. He was previously the Vice President of Investments for Clarke Inc. where he led the investment team. Prior to joining Clarke Inc., Dr Haw was an investment analyst at Geosam Capital Inc., a private investment company specializing in small and mid-capitalization companies, with a focus on real estate and industrial investments. Dr Haw holds a B Sc. (2006), PhD in Physics from the University of Western Ontario (2012) and is a CFA Charterholder (2016).

Mitch Gilbert - CIO

Mr. Gilbert joined TerraVest in 2013 with responsibilities in sourcing, negotiating and consummating mergers and acquisitions opportunities as well as evaluating organic growth investments and new market opportunities. Prior to joining TerraVest, Mr. Gilbert was at a National Bank for 14 years in the Mergers & Acquisitions and Diversified Groups. Mr. Gilbert holds an undergraduate degree in Commerce from McMaster University, an MBA from the Ivey School of Business and is a CFA Charterholder.

There are no specific performance targets mentioned in TerraVest’s compensation policy. A committee of the board of directors determines the compensation by its objective to attract and retain executives. I believe this can certainly be improved upon by aligning key management compensation to free cash flow growth. Note that there are no provisions (such as revenue growth targets) which would let the management go on an empire building spree and pursue growth at any cost.

G.  Valuation summary

Intrinsic Value of the “as-is” TerraVest

To understand whether TerraVest is undervalued, we need to understand how much value the market is ascribing to the operations in place and the growth opportunities. To compute the intrinsic value of TerraVest “as-in”, I take a simplistic set of assumptions as follows:

• TerraVest stops making any new acquisitions and operates the current businesses “as is” for the next 5 years;

• 2% inflationary annual revenue growth;

• 14% flat EBITDA margin in line with the historical average;

• the current working capital levels are sufficient;

• maintenance capex will grow in line with revenue (2% y-o-y growth); and

• 10% discount rate and 2% long-term growth rate.

As presented in Figure 24 below, after taking the assumptions, the value of the current business of TerraVest is $29.6 per share. This compares to the current share price of $26.4 and implies that the market is currently valuing TerraVest below the intrinsic value of its current in-place business and ascribing no value to the exceptional acquisition and capital allocation history of TerraVest’s management. TerraVest’s acquisition strategy has already yielded superior returns on invested capital and tremendous wealth for its shareholders over the last 9 years. If management continue pursuing its disciplined acquisition strategy, TerraVest will continue to generate incremental shareholder value. Overall, market is clearly undervaluing TerraVest.

H.  Risks

M&A Market Conditions and Deal Flow

Market conditions and competition from other acquirers and private equity might prevent TerraVest from completing acquisitions at reasonable valuations. If it must pay higher multiples for transactions, it will reduce the overall return on invested capital. However, there are two main mitigating factors. First, historically TerraVest’s management opted to wait instead of paying a premium to get the deal done. I believe the management will continue to play the wait and see approach. Share buybacks and debt repayment are always good options for capital allocation if acquisition opportunities dry up. The current interest rate environment should deter competition from PE firms. Further, baby-boomer led businesses will be coming up for sale over the next few years as they go into retirement, which should ensure good deal flow for TerraVest.

Operational Risks

For the HVAC sub-segment, unusually warm winters can result in reduced heating requirements that have a negative impact on the demand for these segment products. Increased costs relating to home heating with oil, including heating oil costs and related home insurance costs, as a percentage of consumers’ disposable income could also be a factor that negatively influences steel tank and/or furnace replacement decisions. Another factor is home resale activity which can be a driver of replacement residential oil tank sales, as homeowners and insurers conduct inspections and identify aging tanks during the purchase and sale process. Reduced activity in the residential home resale market could lead to reduced demand.

As discussed earlier, the Processing Equipment and Services segment are highly dependent on oil and gas capex and opex cycles. Processing Equipment revenue can be quite volatile year on year. Normally, the company's Processing Equipment segment and Services segment tend to be a natural hedge against the Fuel Containment segment with respect to oil & gas prices.

I.  Conclusion

At the current share price of $26.4, and an intrinsic value estimate for the “as-is” business of $29.6 per share, TerraVest presents an upside opportunity of ~12%. However, I expect that there will be substantial further upside created through acquisitions and buybacks. I am confident in the management’s ability to keep acquiring 1-2 niche businesses each year at reasonable valuations. I am also cautious of risks relating to oil and gas commodity cycles for the Processing Equipment and Services business segments and challenges it presents for organic growth.

Thank you for reading my deep dive on TerraVest. Please let me know how I could have done better by reaching out to me on Twitter @FairwayResearch.

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Disclaimer: This report is only for educational purposes and is not meant to be investment advice. Readers should do their own due diligence before investing.

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Thoughts on small cap stocks

I have been toying with the idea of whether small cap stocks belong in my portfolio. Ideally, I would like my portfolio companies to be of a certain size and scale. Just to put a number to it, say companies above $300 million in market capitalization. Such businesses have detailed annual reports, investor presentations and conference call transcripts to help me get a better sense of the business. Small cap stocks often lack information because they cannot afford to have a proper investor relations department. However, analysing Atlas Engineered Products (“Atlas”), which has a market cap of only $50 million, has made me realize that studying small business can sometimes bring a different type of satisfaction. Why do I say that? In my experience, small businesses:

• have simple stories and evolution which can generally be summarised in 1-2 pages

• have 2-4 main products which cater to a particular niche market

• tend to be driven by 2-3 main players in the management

• have easy to understand financial statements and historical data

In my view, Atlas embodies all the above characteristics. Since this is a shallow dive, I borrow heavily from write-ups and research reports previously written about Atlas by others on FinTwit. All figures are in Canadian dollars, unless stated.

Atlas Overview

Ticker: AEP

Exchange: TSX Venture

Market Cap: $52 million

Enterprise Value: $55 million

LTM Revenue: $61 million

Auditor: PwC

Business Description: Atlas designs, manufactures, and sells engineered roof trusses, floor trusses, and wall panels in Canada. The company’s main customers are builders of residential and commercial wood-framed buildings, including single-family homes, townhouses, multi-story wood-framed residential buildings, commercial buildings, and agricultural structures. The company was incorporated in 1999 and is based in Nanaimo, Canada.

Product Revenue Breakdown:

Atlas makes 76% of the its revenues from trusses. A wood truss is a structural frame that relies on a triangular arrangement of shorter lengths of lumber and are important for the structural integrity of the building.

Strategy: Atlas is a serial acquirer. It operates in a highly fragmented industry with over small 200 truss manufacturers in Canada. Truss manufacturers in Canada are mostly mom and pop establishments which have $3-$15 million in revenue. Atlas opportunistically buys companies which are small in size and have no succession plan or exit strategy in place. The serial acquirer strategy has made Atlas one of the largest truss manufacturers in Canada (among the top 2, other one being a PE firm based in Winnipeg).

Between, 2018 and 2022 Atlas acquired 8 companies for close to $28 million (including land) in total. The average deal size was $3 million. Atlas on average paid 4x EBITDA for the acquisitions. Currently, Atlas itself also trades close to 4x LTM EV / EBITDA.

The roll up strategy of Atlas has benefits such as increasing efficiencies post acquisition by reducing redundancies (synergies). For example, Atlas can quickly improve EBITDA margins of the acquired companies by centralizing functions such as accounting and admin. Atlas can also consolidate raw material (lumber) supply, develop manufacturing best practices and adopt automation. Independent operators do not have the financial resources needed to improve operations and adopt automation. Atlas also has a dedicated sales team which it can leverage to drive revenue for the acquired businesses. Independent facilities often have customer relationships concentrated with the owners themselves.

Risks:

Atlas’ material cost is 46% of revenue. Its main raw material is lumber which has seen huge volatility in prices over recent years. While the price of lumber has stabilized as of January 2023, any future increases in lumber prices can put pressure on Atlas’ margins as it cannot pass on the increase in cost to customers immediately.

Atlas’ business is also heavily dependent on housing starts. As per forecasts, the housing starts in Canada are expected to be weaker in 2023 and 2024 as compared to 2021 and 2022.

Conclusion

Atlas moves into my watchlist for the next 2 to 3 quarters. I will be closely tracking and studying the company to get more comfortable around the business and managements next acquisition. If you are interested to learn more about Atlas the below sources might be helpful.

Further reading:

Report by COROA Equity Research

Atlas Investor Presentation

Small cap discoveries interview with Atlas CEO, Hadi Abassi:

Write up by Simon Handrahan:

Margin of Safety Investing

Atlas Engineered Products $AEP.V

DISCLOSSURE: Please note that I own shares in Atlas Engineered Products. This is only a discussion of my current thoughts on the business and is not advice of any kind. Some people might be reluctant …

Read more

3 years ago · 18 likes · 1 comment · Simon Handrahan

Summary Deep Dive:

• Aritzia Inc. (TSE: ATZ, “Aritzia”) is a women’s apparel company which operates 115 boutiques in Canada and the United States. The company is headquartered in Vancouver, Canada. As of January 27, 2023, Aritzia had a market capitalization of $5,220 million and FY2022 revenues of $1,495 million.

• Aritzia operates as a design house which has several different in-house brands which are sold through its stores and artizia.com. Aritzia currently sells its products under 10 main brands, that are, Babaton, Ten by Babaton, Wilfred, Wilfred free, Tna, TnAction, Super World (Super Puff), Sunday Best, Reigning Champ and Denim Forum. Aritzia’s products are priced at a premium and are positioned as ‘Everyday Luxury’.

• From FY2008 to FY2023, Aritzia grew its store count from 28 stores to 115 stores as of November 2022 as at compounded annual growth rate (“CAGR”) of 10%. Aritzia has 67 stores in Canada and 48 stores in the U.S. Its average store size is 8,000 square feet; however, flagship stores are often as big as 14,500 square feet.

• Driven by the move to online during the pandemic, Aritzia’s eCommerce has grown from 12% of revenue in 2016 at the time of IPO, to 35% of revenues currently.

• Aritzia has attractive store level economics. A new store typical costs $3 million in net investment of capex and inventory. The company generally makes revenue of $1,000 per sq. ft. in the first few years of operation. At an average store size of 8,000 sq. ft., this comes to annual revenue of $8 million per store. The payback period of new stores is between 12 to 18 months translating to an EBITDA margin of 30% per store, and a return on invested capital (“ROIC”) of 80% at store level.

• Management is highly experienced and has healthy ownership in Aritzia. Management’s interests are aligned with shareholder in terms of compensation (Performance Stock Units are linked to revenue and EPS). Management has met its 5-year financial performance goals even with the challenges posed by the pandemic. Board of directors are experienced fashion industry professionals and private equity professionals.

• Management has been good at capital allocation, with consistent share buybacks and reinvestment with a single caveat on small acquisition of men’s wear brand.

• Based on our discounted cash flow model, we estimate that Aritzia’s intrinsic value per share is $65. This represents an upside of 36% from the current share price of $47.3 as of January 27, 2023.

Disclaimer: Fairway Research is currently long Aritzia shares. This report is only for educational purposes and is not meant to be investment advice. Readers should do their own due diligence before investing.

I understand that since this is a long report, some readers might want to take a print out and just mark-up notes using a PDF. I hear you - you can download the PDF below.

Fairway Research Aritzia Deep Dive 2023

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Rest of this report is divided into the following sections:

Introduction

Brief History of Aritzia

Understanding Aritzia’s brand: 5 key pillars

Historical revenue growth and store level economics

Historical financial performance

Management performance and governance

Valuation summary

A.  Introduction

Aritzia Inc. (TSE: ATZ, “Aritzia”) is a women’s apparel company which operates 115 boutiques in Canada and the United States. The company is headquartered in Vancouver, Canada and was founded in 1984 by Brian Hill, a third-generation retailer.

As of January 27, 2023, Aritzia had a market capitalization of $5,220 million and FY2022 revenues of $1,495 million.

B.  Brief history of Aritzia

Aritzia opened its first stores outside of Vancouver in 1999. In 2005, the private equity firm Berkshire Partners took a majority stake in Aritzia and are still present on the board of directors of the company.

In 2007 Aritzia launched its first store in the United States which has now become the largest geographic market for the firm’s products. Its eCommerce website was launched in 2012 and it started shipping its product internationally in 2016. With 74 boutiques open in Canada and the U.S., and a revenue of $542 million in FY2016, Aritzia went for an IPO in 2016 and started trading on the Toronto Stock Exchange. Interestingly, up to 2016, Aritzia had never closed a store in its 32-year history. Aritzia faced a challenging year in FY2021 when Covid-19 led to closure of several of its stores across the U.S. and Canada. However, Aritzia quickly pivoted its business and inventory to focus on online fulfillment and saw exponential eCommerce revenue growth FY2021 and FY2022.

C.  Understanding Aritzia’s Brand: 5 key pillars

To understand Aritzia’s business we need understand its brand. And to understand its brand we need to dig into, what we believe are five key brand pillars:

1.      Product strategy;

2.      Pricing;

3.      Stores / Boutiques;

4.      Ecommerce; and

5.      Marketing.

Pillar 1: Product Strategy

Aritzia operates as a design house with several different in-house brands which are sold through its stores. Aritzia currently sells its products through 10 main brands, that are, Babaton, Ten by Babaton, Wilfred, Wilfred free, Tna, TnAction, Super World (Super Puff), Sunday Best, Reigning Champ and Denim Forum. Aritzia derives 95% of its revenue from these inhouse brands. The remaining 5% of revenue comes of sales of third party branded products such as sneakers (Vans, New Balance).

The company’s primary target market are women between the age of 15 and 45. The brands under Aritzia keep on evolving over time as new ones are introduced in line with current trends. See below the evolution of Aritzia’s primary brands from 2016 to 2022:

As can be seen in Figure 2, over the last six years, Aritzia introduced brands such as TnAction, Super World, Sunday best, Denim Forum and Ten by Babaton. It also continuously introduces various sub brands under its successful brands such as TNA, Babaton and Wilfred. Each brand is treated as a separate label with its own dedicated in-house design team.

The multi brand portfolio and product mix allows enhanced multiple flexibility to address evolving fashion trends, appeal to customers across multiple life stages and style preferences. This also increases the customer base and share of customer’s closet for Aritzia. During the pandemic, the stay-at-home orders led to a decrease in Aritzia’s sales of its professional wear brand Babaton. The company had the flexibility to push other brands which had a more stay-at-home and casual product line.

Pillar 2: Pricing

Aritzia’s products are priced at a premium and are positioned as ‘Everyday Luxury’. Management claims to have lower mark downs of inventory owing to its superior sourcing and inventory management. Aritzia also tends to take a long-term view of brand management and often foregoes short term sales by discontinuing older styles and introducing new ones to maintain brand relevance.

Aritzia’s products are only sold in their stores and on Aritzia.com. The company does not have a third-party wholesale channel for their products.

Pillar 3: Boutiques / Stores

The crucial aspect of Aritzia’s brand are its stores. I like comparing Aritzia’s store experience to that of  Starbucks for coffee. Its stores are meant to be experiential. They have a curated mix of store design, architecture and music. The retail channel contributes 65% of Aritzia’s revenue.

Aritzia’s currently has 115 stores as of November 2022[1]. 67 of those stores are in Canada and 48 are in the US. Its average store size is 8000 square feet; however, their flagship stores are often as big as 14,500 square feet. The boutiques are primarily launched under the Aritzia brand; however, the company opportunistically opens standalone stores under the TNA, Babaton and Super Puff brands. Aritzia’s stores are in either high traffic malls, or high street locations with heavy footfall. The company treats its stores as its main customer acquisition vehicle and major component of its marketing strategy. To elevate the customer experience, some of the stores even have a A-ok café in store. Again, taking its long-term approach to brand management, Aritzia’s management is often willing to wait for the right retail locations which resonate with its brand.

Pillar 4: eCommerce

Aritzia started its eCommerce segment in 2012. It started shipping to international customers in 2016. It currently ships to over 200 countries. Aritzia’s eCommerce business is supported by its concierge team who are often its own former retail store associates. As per the management, whenever a store is opened in a new market, it results in 80% uptick in ecommerce revenue in that area. So essentially both online and retail divisions feed from other in the synergistic manner. Aritzia’s eCommerce division only contributed 12% of revenue in FY2016 at the time of IPO. However, the pandemic supercharged the division, and it now stands at 35% of revenues. As per similar web, the Aritzia.com saw monthly traffic of over 10 million visits during December 2022.

Aritzia’s products are packed aesthetically pleasing packaging adding to the entire online shopping experience. Management as claimed that Aritzia’s omni channel customers, generally spend 3x the amount spent by single channel (eCommerce or retail) customers.

Pillar 5: Marketing

The last pillar of Aritzia’s brand is its marketing strategy. The company does not use traditional media to promote its products. In addition to relying on its physical stores, the company primarily engages social media influencers to promote its products. The brand is also further flued by its popularity among its customers who like posting about their shopping experiences (shopping hauls) on social media platforms such as TikTok where Aritzia has almost 2 billion views. Aritzia’s minimalist store set up is appealing to influencers. In addition to a very active reddit discussion group, Aritzia also has over 1.4 million followers on Instagram. As per Google trends, the search interest in Aritzia has been steadily increasing over the year. It peaks every year around the holiday season. Online interest in Aritzia has been especially strong in 2021 and 2022 (See Figure 9).

D.  Historical revenue growth and store level economics

In this section we will dive into Aritzia’s historical store growth, and its store level economics both for new stores and expanded stores which are a key component of Aritzia’s strategy.

Historical store growth

Aritzia has grown its store count from 28 in FY2008 to 115 as of November 2022 as at annual compounded annual growth rate (“CAGR”) of around 10%. It currently has 67 stores in Canada and 48 stores in the US. Store growth in its home market of Canada has stagnated since FY2019 and most of the growth is coming from the US where is a relatively newer brand.

Between FY2018 and FY2022, Aritzia opened between 5 to 6 new stores each year (27 in total). Further, it also expanded the square footage in 23 of its existing stores during the same period while closing only one store in FY2022.

Store level economics: new stores

Aritzia’s new store economics are very attractive in terms of return on invested capital. A new store typical costs $3 million in net investment of capex and inventory. The company generally makes revenue of $1,000 per sq. ft. in the first few years of operation. At an average store size of 8,000 sq. ft., this comes to annual revenue of $8 million per store. The payback period of new stores is between 12 to 18 months. That translates into an EBITDA margin of 30% per store, and a return on invested capital (“ROIC”) of 80% for every new store. As discussed previously, new stores also lead to 80% uptick in ecommerce sales. That increase is not factored into in the new store economics, so ROIC can be effectively higher than 80%.

Store level economics: Existing store expansion

Aritzia’s store expansion generally involve increasing the existing selling space by 3,500 square feet. The net investment for the expansion is $2 million and a payback period of around 24 months.

Overall revenue growth

Aritzia’s revenue grew from $743 million in FY2018 to $2,002 million for the last twelve months (“LTM”) ended November 2022 at a CAGR of 22%. Out of its total revenue of $2,002 million, $1,325 million (or 66%) was from the retail segment and $677 million (or 34%) was from eCommerce segment.

Retail revenue

At 115 stores, the retail revenue of $1,325 million represents average annual revenue per store of $11.5 million. Note that the revenue level of $1,000 per sq. ft. considered in Figure 12 is for new stores. As stores mature, their revenue per sq. ft. increases. Given that the average size of an Aritzia store is 8,000 sq. ft., the revenue per store of $11.5 million translates to revenue per sq. ft. of $1,437 (See Figure 14). The revenue per sq. ft. is almost flat from level of $1,465 per sq. ft. disclosed in its IPO prospectus in 2016.

Aritzia witnessed same store sales growth (“SSS” or comparable sales growth) of between 7% to 10% between FY2018 to FY2020. After not reporting SSS growth during FY2021 and FY2022 due to store closures, the FY2023 SSS growth came in very promising at quarterly growth in high 20s (See Figure 15). Further, Aritzia’s revenue is bucketed toward Q3 and Q4 of the financial year which together account for 60% of the annual revenue.

eCommerce revenue

Aritzia did not disclose its eCommerce revenue prior to FY2020. However, as per its IPO prospectus, its eCommerce revenue in FY2016 as $65 million. At the current eCommerce revenue of $677 million, it has grown over 10x in the last seven years at a CAGR of 40%.

Geographic breakdown of revenue

For LTM November 2022, Canada, and US both represented 50% of total revenue of Aritzia. It is important to note that US revenue was only 34% of total revenue in FY2021. Over FY2018 to LTM, the US revenue has grown at CAGR of 39% and the Canadian revenue has grown at a CAGR of 13%.

E.  Historical financial performance

In this section, we discuss the 5-year historical financial performance of Aritzia.

Gross profit margins

Over FY2018 to LTM Nov 2022, Aritzia had average gross profit margins of 40%. Aritzia does not own manufacturing facilities for its products and sources them directly from manufacturers. As per the company’s IPO prospectus, it sourced goods from 50 manufacturer with the top 10 vendors contributing 51%. No single vendor contributed more than 10%. The company also does not enter long term supply contracts with vendors. It has a formalized quality assurance program where the factories of manufacturers are audited by a third-party firm to ensure compliance with local laws and global standards.

Selling, general & administrative expenses

Aritzia’s SG&A expenses increased from $184 million (25% of revenue) to $551 million (28% of revenue) for LTM November 2022. Around 80% of Aritzia’s SG&A expenses are comprised of employee costs.

Employee costs

The company’s employee costs increased from $148 million in FY2018 to $440 million for LTM November 2022, growing at CAGR of 24%, that is, slightly higher rate than growth of revenue (22%) during the same period. Aritzia employed 6,569 personnel (excluding seasonable workforce) as of February 2022. 4,410 of those staff work in Aritzia’s stores, 1,487 work in support and 672 work in the distribution centres. Aritzia also employs seasonal workers during peak season. The average salary per Aritzia employee in FY2022 was around $48,000 per year.

The number of employees per boutique has increased substantially from 24 in FY2020 to 42 in FY2022. In other words, the retail revenue per employee has decreased significantly from $329K in FY2020 to $211K in FY2022. This indicates decreasing retail employee productivity, however at a company level the margins are strong because eCommerce, which is a higher margin business, has gained share in overall revenue. It will be interesting to see how this figure trends over time.

EBITDA margin

With the exception of FY2021, Aritzia’s EBITDA margin during FY2018 to FY2022 averaged ~17%. EBITDA margin for LTM November 2022 was lower compared to FY2022 due to lower gross margins.

Capital expenditure

Between FY2018 and FY2022, Aritzia on average spent $60 million per year on capital expenditure. For LTM November 2022, Aritzia has spent $104 million in capital expenditure. Capital expenditure was relatively higher due to construction of a new 550K square feet distribution centre in Vaughan, Ontario which will replace one of the existing 150K square feet third party operated distribution centre. In FY2022, the company also acquired a 75% stake in the men’s athletic brand, “Reigning Champ”, for $33 million.

Working Capital

Aritzia’s working capital averaged at 4% of revenue between FY2018 and FY2022. The average inventory days where 80 and the average payable days where 40. Aritzia’s inventory increased significantly between February 2022 and November 2022 to 159 days. It seems to be a strategic decision by the management, since Q4 tends to the biggest sales quarter for Aritzia, and the firm did not want to sales due to low inventory. Management also noted that most of the inventory is concentrated in client favorites.

“As a reminder, we had extremely low inventory levels in the back half of last year, which negatively impacted sales. We made the strategic decision to order future season buys earlier in order to build back our inventory base, mitigate supply chain risk and ensure our ability to fuel the robust demand for our product. Due to the improved lead times, product has been arriving even earlier than anticipated, accentuating the comparison to the prior year.” - Todd Ingledew, CFO, Aritzia Q3 FY2023 Conference Call

Return on invested capital

Aritzia’s return on invested capital is in high 30s. Considering that Aritzia has 80% ROIC at the store level, this is not a surprise.

F.  Management performance and governance

Key Management Compensation, tenure and alignment

You can read about the management and board of directors of Aritzia from here. The board of directors includes private equity partners (Berkshire)and former executives from well know fashion companies such as Aldo, Lululemon, Mountain Equipment Company (MEC) and SSense.

The key management (Brian Hill and Jennifer Wong) have been running the business for decades. Brian Hill, who is the founder of Aritzia, stepped down in 2022. Jennifer Wong has replaced him as the CEO and had been previously serving as the president and COO2. However, Brian Hill still remains deeply involved in the business and holds 18.7% equity interest. He recently sold a part of his equity interest for estate planning and diversification purposes.

As per SimplyWallSt, CEO’s total compensation is below average for companies of similar size in the Canadian market. Aritzia’s CEO compensation included equity-based compensation awards for a total annual compensation target of $3 million, comprised of 50% in stock options that vest over a five-year period, and 50% in performance share units with the targets tied to Aritzia long term performance. Net sales (50% weighting) and adjusted earnings before interest and taxes (50% weighting) are the performance criteria for PSUs granted in FY2022. We feel this aligns the interests of management and shareholders of Aritzia.

Employee satisfaction and culture

The company current has a Glassdoor rating of 3.6. This is not the greatest. However, employees noted that they do get good discounts on products (40%).

Financial performance of management

At the time of its IPO in 2016, Aritzia set certain financial goals, included doubling its total revenue and increasing eCommerce to 25% of total revenue. The management has surpassed all goals quite comfortably even with the challenging environment for retail business during the pandemic.

Capital Allocation

In addition to reinvesting in the business for growth, the management has been opportunistically buying back shares. Since its IPO, Aritzia has bought has 8.7 million shares for $187 million. Average cost comes to $21 per share which is less than half of the current share price of $47.3. In January 2023, the company issued another normal course issuer bid where it may purchase up to 3.9 million shares.

The company made a single acquisition of a men’s wear brand which has 4 stores. However, the transaction is very small in the overall scheme of things for now. It will be interesting to see how this transaction pans out for Aritzia.

Further as of November 2022, the company did not have any financial debt (only capitalized leases).

Conclusion on Management and Governance

Overall, regarding the management and governance of Aritzia, we conclude the following:

• Management is highly experienced and has healthy ownership in Aritzia.

• Management’s interests are aligned with shareholder in terms of compensation (Performance Stock Units are linked to revenue and EPS).

• CEO compensation is below industry level.

• Historically, management has met its 5-year financial performance goals even in a pandemic.

• Management has been good at capital allocation, with consistent buybacks and reinvestment subject to one caveat on small acquisition of men’s wear brand.

• Board of directors are experienced industry professionals with private equity professional helping in maintain overall balance of the board.

G.  Valuation summary

Key assumptions for projections:

Revenue: We estimate that Aritzia’s revenue will grow from $2,002 million in LTM November 2022 to $3,643 million in FY2027 representing a CAGR of 16%. This will be driven by retail revenue and eCommerce growth.

Retail Revenue: In line with management guidance, we expect the firm to open 8 to 10 stores per year and reach around 150 stores by end of FY2027. Historically the management has executed on 5-6 new stores per year. Accordingly, 10 stores per year it not big execution risk. We keep Canadian stores constant with growth coming from increased penetration in the U.S.

Flued by store expansions and growth in the U.S., we expect revenue per store to rise from $11.5 million in LTM November 2022, to $14 million in FY2027.

eCommerce Revenue: We project eCommerce revenue to grow to $1,500 by FY2027. This is in line with management guidance. We can’t do a deeper analysis on this because of the lack of data points, but eCommerce has shown good historical growth.

Gross and EBITDA margin: We assume gross margins of 42% throughout the projection period. That is 200bps higher than the average gross margins of the company during FY2018 to FY2022. We believe as eCommerce’s share of total revenue and the share of U.S. in total revenue grows, the gross margins will expand. Accordingly, we expect EBITDA margins to steadily increase to 19% by terminal year.

Capex: We have considered total capital expenditure of $500 million during FY2024 to FY2027 at $125 million per year. This is in line with management projections. This will be spent on distribution centers and store expansion.

Working capital: We project that the elevated inventory levels will normalize over the next 2 years and reduce from 158 days of inventory to 75 days of inventory in FY2026.

Discount rate and Exit EBITDA multiple: We use a discount rate of 10% for all our analysis. While, it is contrary to investment theory, it helps us compare investments on an apples-to-apples basis. As much as possible, we try to factor in all company specific risks into the cash flows.

We assume an exit EBITDA multiple of 13x. This is meaningfully lower than the current LTM EBITDA multiple of 18x. However, even if the multiple goes down to 10x, the intrinsic value estimate is about $52.

A.  Risks and Opportunities

Risks:

• Key will be to track how Aritzia is able to maintain its brand relevance over the next 3-5 years. Social media is ever evolving and fashion trends are often fleeting. The company has shown an ability to always stay on top on fashion trends and maintain brand value.

• Store employee productivity seems to be declining. Coupled with wage inflation, this can turn out to be a big concern for the company’s cost structure and can put pressure on margins.

• There is intense competition in the North American Women’s apparel industry with low barriers to entry.

Opportunities

• Projections do not model growth beyond North America into Europe and China which are very likely big markets for Aritzia in the future. We believe Europe and China will be key markets for Aritzia’s expansion beyond FY2027.

• The company’s recent acquisition of a men’s wear brand (Reigning Champ) and launch of Super Puff jackets for men will open new opportunities in the men’s apparel category.

B.  Conclusion

At the current share price of $47.3 per share, and an intrinsic value estimate of $65 per share, Aritzia presents an upside opportunity of ~36%. We are confident in the management’s ability to scale the business over the next five years. We are also cautious of risks relating to competition and maintaining brand relevance.

Q4 FY2023 Update

You can read my views on Aritzia’s Q4 FY2023 results in this Twitter thread:

https://twitter.com/FairwayResearch/status/1653601816880242690

Thank you for reading our deep dive on Aritzia. Please let me know how I could have done better by commenting below or you can reach me on Twitter @FairwayResearch.

Disclaimer: Fairway Research is currently long Aritzia shares. This report is only for educational purposes and is not meant to be investment advice. Readers should do their own due diligence before investing.

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“Fairfax India’s current discount to NAV is so undemanding that just the value of its non-airport investments (the majority of which are publicly traded), net of corporate borrowings is nearly equal to the current market capitalization of the company; meaning investors today are getting the airport for free.” – Trevor Scott, Tidefall Capital LP, Q4 2022 Letter

Introduction

Fairfax India Holdings Corporation1 (TSE: FIH.U, “FIH”) is the investment vehicle used by Fairfax Financial (Prem Wasta) for making investments in Indian public and private companies. It is a unique equity vehicle, which gives Canadian investors exposure to Indian businesses. In this short report, we use the discounted cash flow model to estimate the intrinsic value of Bangalore International Airport Limited, which represents almost half the net asset value of FIH.

Intrinsic Value Methodology

Because FIH operates similar to a fund, the best way to estimate the intrinsic value of FIH is to analyse its net asset value (“NAV”). Before computing NAV, it is important to note how FIH accounts for its investments.

FIH’s Investments are carried on the balance sheet at fair value (instead of cost). Accordingly, the book value of FIH should closely follow the market value or fair value of investments. Further, FIH’s investments in public listed companies are simply valued using their respective market prices and investments in non-listed private companies are valued using internal valuation models such as discounted cash flow. However, retail investors do not have access to such models and accordingly getting comfort around the NAV of FIH can be challenging.

The biggest investment within FIH is its 49% equity stake in Bangalore International Airport Limited (“BIAL”), which operates one of India’s largest airports. At FIH’s internal fair value estimate of $1.26 billion, the BIAL investment alone accounts for 45% of the NAV.

While I do not believe markets are always efficient, as an investor I can take comfort in the fact the public investments of FIH can be, at minimum, sold at market prices. It really just comes down the how an investor can get comfortable around the BIAL fair value. After all, it is a large private investment in an emerging market infrastructure asset where I do not know what exactly went into the FIH’s valuation model. But the more I know the lesser my risk. Hence, I choose to dig into 400 page annual reports and several regulatory filings to get some sense of the intrinsic value of BIAL.

Bangalore International Airport

Situated in Southern India, Bangalore is one of the fastest growing cities, not just in India, but in Asia pacific as well.

Growth before the pandemic

Prior to Covid-19, BIAL showed impressive growth in passenger figures growing at 13% CAGR from 11.6 million in FY2011 to 26.9 million in FY2018. Note that during FY2011 to FY2018, BIAL only operated terminal 1 which had a capacity of 26.5 million passengers per year. So BIAL was running fairly above capacity by FY2018.

Impact of Covid-19

Of course, just like any airport in the world, BIAL was impacted by several waves of Covid-19. Passenger numbers fell from 32.4 million in FY2020 to 11 million in FY2021, before recovering partially to 16.3 million in FY2022. It is heartening to know that even in the middle of the pandemic, BIAL maintained positive EBITDA.

Regulated revenue

BIAL makes revenue through primarily through two sources. First being aeronautical (aero) revenue earned from activities relating to operations of aircrafts and cargo.2 Second is non-aeronautical revenue, which includes car park, retail, real estate, advertising etc. The aeronautical part of the revenue is regulated by Airports Economic Regulatory Authority (“AERA”) which comes out with a rate order for every 5-year period3. AERA takes into account several things while setting the aeronautical revenue rates, such as fair return on equity, capital expenditure, operating expenditure and non-aero revenue. In 2021, AERA come out with its tariff order for BIAL for the period FY2022 to FY2026. It includes detailed projections relating to BIAL’s revenue, costs and capex for this period. While, BIAL might underperform or over achieve these projections, these projections serve as a guide post for estimating the free cash flow and intrinsic value of BIAL.

Revenue Projections

The traffic projections are the key input in every airport. In November 2022, BIAL completed the construction of phase 1 of terminal 2, doubling its capacity from 26.5 million passengers per year to 52.5 million passengers. AERA’s 2021 order estimated that that the passenger traffic at BIAL will fully recover in FY2023 to reach 31.2 million. They seem to be right, as BIAL has already processed 16.3 million customers between April 2022 and October 2022. That is, they have already surpassed FY2022 traffic figures within 7 months of FY2023 and are on track to do volumes of around 30 million in FY2023.4

While FIH has future plans for construction of Terminal 2 phase 2 and Terminal 3, the airport in its current state is expected to operate at 94% of capacity by FY2026. Higher traffic will fuel higher aero and non-aero revenue for BIAL during the projection period.

EBITDA margin

There are significant scale advantages to operating an airport. Prior to the pandemic, in FY2019, BIAL had an EBITDA margin of 69%. While the margin dipped during the pandemic, but remained at a respectable 40% in FY2022 even with half the passenger traffic. It is expected to increase to 75% by FY2026. BIAL’s major expenses such as personnel expenses and O&M demonstrate high economies of scale. The only expense expected to proportionately increase with revenue is the concession fee, which is set at 4% of aero revenue.

The Hyderabad airport (operated by GMR) which is also located in South India, reported an EBITDA margin of 60% in H1 FY2023. Given the historical EBITDA margins witnessed by BIAL prior to the pandemic and the fact the closest major airport also has reasonably high EBITDA levels, gives me comfort that EBITDA projections for BIAL are reasonable.

Capital Expenditure

Airports are capital intensive. As per AERA, BIAL will incur total capital expenditures of close to $1.06 billion during FY2022 to FY2026. Majority of this is for completion of Terminal 2 and other fresh projections. However, as of March 2022, BIAL has already spent $623 million (capital work in progress on the balance sheet). Hence, for the projection period of FY2023 to FY2026, BIAL will only need to spend the remaining $442 million of capex.

BIAL Discounted Cash Flow Valuation

FIH fair values its stake in BIAL at $1.26 billion as of September 30, 2022. If we do a simple back calculation, considering the projections discussed above, and taking a 13% discount rate5, BIAL will need to go for an IPO or sale at 17.5x EV / EBITDA multiple at the end of FY2026 to reconcile with FIH’s fair value estimate of $1.26 billion.

BIAL’s competitor in the Indian airports space, GMR, which operates the Delhi and Hyderabad airports, currently trades at 21x LTM EBITDA. Accordingly, sticking with 17x EBITDA multiple seems conservative.

While the above DCF valuation seems reasonable, I note the following:

• BIAL is a growing infrastructure asset which is yet to fully expand to its potential. AERA vetted cash flows do not take into account the construction of terminal 2 phase-2 and terminal 3 (these can easily take passenger capacity of the airport to 90 million plus per year from the current 52.5 million).

• If FY2023 is any indication, BIAL will likely surpass the current AERA projections to some degree

• There can be significant upside beyond FY2026 from the 400 plus acres of adjoining land to the BIAL airport

Other indications of relative value

In September 2021 OMERS bought 11.5% interest in BIAL. The transaction valued 100% of BIAL at $2.6 billion. This value is also pretty much in line with the both FIH internal fair value estimate and intrinsic value estimate based on the above DCF.

FIH’s discount to NAV

As shown in Figure 9 below, if we accept FIH’s current valuation of BIAL equity stake, then FIH is trading at 27% discount to NAV. In other words, the share price has to increase by 38% from the current levels to meet the intrinsic value (this represents my margin of safety). We can also turn this around, and back calculate the fair value being ascribed by the market to FIH’s BIAL equity stake, which comes to $525 million (See Appendix 1). Implying a 100% valuation of BIAL at close to $1 billion. As of today, that scenario is unlikely.

Other private equity investments of FIH

There is of course the risk that, as an investor I cannot get comfort around the intrinsic value of other private equity investment which are valued at $816 million. They make up 30% of the NAV. The deviation in value of these investments is a known risk.

Conclusion

Given the above discussion around the valuation of BIAL, FIH’s biggest investment in India, I estimate that the intrinsic value of FIH is somewhere close the current NAV of $19 to $20 per share. The discounted cash flow valuation based on AERA projections gives me sufficient comfort around BIAL’s intrinsic value. FIH has previously traded at above NAV (see figure 10) and the discount to NAV can quickly close as investors see an improvement in BIAL’s results or an earlier push for an IPO.

Fairway Research thanks Trevor Scott (@TidefallCapital) for covering Fairfax India in his Q4 2022 newsletter.

This document is only for educational purposes. Fairway Research holds a long position in Fairfax India.

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Cost of equity assumed as 20% and cost of debt as 9%, with 50% weighting to each.

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