In advance of its recent Annual General Meeting in late November, SDI released a trading update for the first six months of FY16. While management reaffirmed their FY17 sales guidance of 10% growth for non-amalgam sales and flat amalgam sales, they also provided profit guidance for the first half of $2-2.5m which will be down from $3m achieved in the first half of FY16. The market was disappointed by the profit guidance which management explained reflected in part some material currency moves.We view short term currency impacts as normal for a company growing its international revenue base en-route to becoming a global market leader, however we question if the currency exposure could have been better managed by the company. The market obviously under-estimated currency as a short term risk to profit, given the selling that followed.
While acknowledging that currency movements will impact a business that exports 90% of its sales, we cannot defend the way management communicated the reasons at play behind this lower earnings guidance. Rather than providing the details expected to keep public markets properly informed, management opted to provide minimal information and clarity. As a result, it was not a surprise to see the stock sell off quite significantly. Ironically, it is this poor market communication which forms part of our investment thesis looking forward.
Our Investment Thesis Reaffirmed
There is no fundamental change in our investment thesis. We view SDI as an emerging global leader in a defensive growth market which is well placed to grow consistently at 3-4% p.a. with minimal correlation to the global economy. As the chart below shows, the company has experienced strong growth in Europe and Brazil in FY16 which has been partially offset by US weakness.
Our investment thesis very much depends upon the continuation of two structural transitions the company is currently going through:
1. A shift away from amalgam product sales towards non-amalgam product sales – this remains very much on track with continuing strong growth momentum in glass ionomers and whitening product (non-amalgam) sales momentum in local currency,
2. A (gradual) shift away from a private family company way of managing and communicating towards publicly listed market standards – this is arguably the slowest moving part of the investment thesis as evidenced by the company’s disappointing handling of this earnings downgrade announcement.
The company continues to be profitable, and has a strong balance sheet with a net cash surplus which leaves it well positioned to fund future growth.
We view the current share price as under-valuing SDI given the significant potential earnings growth we believe lies ahead in the coming years. The SDI business model benefits from excellent operational leverage so shareholders are well placed to benefit from strong future non-amalgam revenue growth. As a result, we remain confident that the current share price provides ample margin of safety.
The stock had arguably attracted some shorter term investors in the recent rally. One investor recently said to us that “SDI had become the poster child of smaller company value investors, some of whom joined the bandwagon late”. We view the recent sell-off as an opportunity to re-focus the shareholder base on the company’s long term objectives. The recent passing of SDI stock from impatient to patient investors can only be a good thing for long term shareholders.
Some Messages for Management from a Long Term Shareholder
Please communicate clearly and if possible ahead of time. Your long term and supportive shareholders are likely to look through minor short term disruptions like this if you communicate openly and in advance, and not surprise them with poorly communicated disclosures. In the event there is an unforeseen event, it is always best to open up and give the market a frank, honest and detailed account of what has happened. Investors will pay a premium for high quality management, and high quality management communicates well.
Please provide details on the evolution of underlying earnings when there are numerous factors at play – ie. it is often more meaningful to strip out any one-off factors when appropriate to provide a clear picture of how the business is actually evolving. For example, when providing guidance, it may have been prudent to strip out or at least explicitly explain the one-off effects of currency translation or other abnormal items.
Beyond this, we appreciate Management’s focus on positioning the company for long term growth. The process of unlocking the value in the business is an exciting opportunity for your long term shareholders.
Our Investment Process at Play
As value investors, we view short term weakness as an opportunity when the long term investment thesis remains intact, like now.
We view recent SDI share price weakness as good news for our investors since it provides the opportunity to purchase more stock at an attractive valuation with a significant margin of safety.
SDI remains a core long term holding for DMX and the TAMIM Australian Equity Small Cap poortfolio. We look forward to a long-term partnership with SDI and believe our investors will benefit.
Happy Investing,
