Not many companies have prompted analysts to upgrade their earnings forecast four times in the past year, but technology group Elektron Technology (EKT:45p) is one such company.
Key to this transformation in the company’s profitability has been the turnaround of Bulgin, a world-class designer and maker of hermetically-sealed (air and watertight), fail-safe circular connectors used to supply electricity and other vital equipment, often in harsh environments. Products manufactured include waterproof circular connector range (power, signal and data), mains connectors, battery holders, indicators, and vandal-resistant LEDs and switches.
Bulgin is hugely profitable, boosting operating profit by a quarter to £9m in the 12 months to the end of January 2019 on revenue up 10 per cent to £30.1m. A return on capital employed of 300 per cent for this business tells you everything as does a market-leading operating margin of 30 per cent. It’s hugely cash generative, too, which is why even Elektron’s net cash almost doubled to £10.1m in the 12-month trading period.
A gross margin of 50 per cent reflects the strategic focus on growing high-margin products – 10 per cent of last year’s sales were derived from products launched within the past three years – and the fact that 60 per cent of the product offering, and 90 per cent of connector sales, are “designed-in” to clients system applications, thus creating an economic moat around the business, stickiness of revenues and a barrier to entry for rivals.
By cutting the number of distributors from 300 to 75 in the past seven years, incentivising them to push Bulgin products, and providing technical support to customers, Bulgin has expanded its end-user base (up 14 per cent to 92,000 customers last year) and now makes over 90 per cent of sales through its distribution channel. Technological advances are helping drive sales growth, too, as the company embraces the fourth industrial revolution and exploits demand for smart and autonomous systems fuelled by data and machine learning. End-user demand in ruggedized fibre and sensor markets is growing at around 15 per cent a year, according to the directors, and there are plans to launch eight new products in the current financial year to leverage off this underlying market growth.
Bulgin’s like-for-like sales growth of 20 per cent in the first three months of the new financial year to the end of April 2019 suggests that demand from its end markets – automotive, consumer electronics, automation, industrial, marine, telecom, oil & gas and lighting applications – remains robust enough to support forecasts of analyst Paul Hill at Equity Development that suggest divisional operating profit can rise from £9m to £10.3m in the 12 months to the end of January 2020 on revenues up almost 6 per cent to £31.8m. It’s hardly surprising that Elektron received a bid approach a few months back for the division at a price well in excess of its own market capitalisation.
Checkit transformational acquisition
The benefit of having a hugely cash-generative high-margin business is that Elektron has been able to heavily invest in its other core business: Checkit, a proprietary work management ‘software as a service’ (Saas) product that has been designed to replace paper-based systems with a centralised, interactive cloud-based way of managing the multitude of tasks that staff have to carry out on a daily basis.
Its interactive checklists actively prompt staff to perform tasks when and where they are required to. Completed tasks are then time stamped and sent to the cloud to provide an audit trail of work carried out and issues that have arisen. The addressable market is estimated to be worth around £272m in the UK alone, with hotels, pubs and restaurants (36.8 per cent share), retail, travel and leisure (22.4 per cent), and food service (14 per cent) the key sectors,
This business has been growing strongly, doubling sales to £1m last financial year, but is still lossmaking, reporting an operating loss of £4.5m. However, prospects have been transformed following last month’s earnings-accretive £8.8m acquisition of Fleet-based Next Control Systems (NCS), a leader in high-end service based temperature monitoring for healthcare and life sciences within the UK, and data-related Building Energy Management System services. NCS has a major relationship with a leading UK retailer covering smart building and plant technologies. The business is very profitable, too, reporting an operating profit of £1.2m on revenue of £10.7m in 2018.
It looks like a compelling strategic fit, adding immediate scale to Checkit, increasing turnover eightfold and providing opportunities for further sales growth and improvements to operational capabilities, including: cross-selling Checkit's Work Management product to NCS’s customer base; diversifying that customer base and extending the offering across additional vertical sectors alongside the food service sector; enhancing Checkit's existing range of sensors; and leveraging NCS’ sales capabilities to improve Checkit organic growth in the UK and overseas.
Integration costs of £400,000 to £500,000 will be a small price to pay if Elektron’s management can double NCS’s operating profit within the next two to three years, driven by self-help measures (improved pricing, contract management, and procurement), and scaling up the business. Mr hill predicts the Checkit/NCS business will report reduced operating losses of £3.9m in the current financial year and £2.7m in 2020-21.
Profit momentum building
After factoring in a £200,000 operating profit contribution from the non-core Elektron Eye Technology (EET) division, a business that has developed portable analysers that are used to detect age-related macular degeneration, then it’s easy to see how Elektron’s pre-tax profit is set to surge again this year even having risen from £2.6m to £4.6m in the 12 months to the end of January 2019. Mr Hill is pencilling in a pre-tax profit of £6.4m and earnings per share (EPS) of 2.7p (2.1p in 2019), rising to £8.4m and 3.5p, respectively, in 2020-21 as losses from Checkit/NCS narrow further. After settling the NCS acquisition consideration, expect net funds of £3.2m by January 2020, but that excludes potential net proceeds of around £2m from a likely disposal of EET, so cash will start building again.
On this basis, the shares are rated on just 15 times current year’s earnings estimates, falling to 12 times estimates for the 2020-21 financial year, hardly a punchy rating for a company that has a realistic chance of boosting EPS by 67 per cent over the next two financial years.
So, having first advised buying the shares at 44p, in my November Alpha Report, and reiterated that advice earlier this year (‘Elektron’s strong earnings momentum significantly underpriced’, 12 Feb 2019), I have no hesitation maintaining my buy recommendation with the shares priced on a hefty discount to my 70p a share sum-of-the-parts valuation. This is based on a valuation of £105m (56p a share) for Bulgin on the basis of a multiple of 13 times net profit estimates for the current year; £20m (11p a share) for the Checkit/NCS business; and £5m (3p a share) for net cash and EET. Buy.
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