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Oxford Instruments: a clever business making clever products

Oxford Instruments has many of the characteristics of a high-quality business. It is going through a tough time at the moment, but it has a long-term strategy and exposure to attractive end markets that may reward patient investors
Oxford Instruments: a clever business making clever products

The UK’s manufacturing base may have been whittled down to a shadow of its former self, but what remains tends to be very good. The stock market contains fine examples of UK-based companies in specialist engineering sectors that have thrived in recent years. They have done so because they provide niche, innovative products and services that help their customers solve problems and make their businesses better. Companies such as Spirax-Sarco, Halma and Renishaw readily spring to mind here and have served their long-term investors very well indeed.

Oxford Instruments looks as though it fits a similar mould. The company was a commercial spin-out from Oxford University in 1959. Today, its products exist to help its customers improve their research and development (R&D) efforts, improve manufacturing productivity and make new scientific discoveries. These are the types of characteristics that can create very profitable businesses that are hard to copy, so I’ve decided to take a closer look at what makes this company tick.

 

Making clever products to help others make clever products

One of the key challenges that investors face when coming across a business like Oxford Instruments is that their initial impression is that it is too difficult for them to understand and they decide not to bother researching the company. It’s very easy to be bamboozled by technical jargon and processes that only those with a familiarity with the industry understand, but usually there is a way around this that can prove very worthwhile. I must admit, I often find myself reaching for my dictionary when looking at these types of companies.

For me, the key is to focus on what the company’s products are trying to do and what markets they are selling into. If they are solving problems and helping businesses in markets that have decent long-term growth prospects then you may have the makings of a decent investment opportunity.

The simplest way I can describe Oxford Instruments is that it is a business that makes clever products that help its customers make new clever products or make their existing products better.

These products come in many forms, including:

  • Scientific digital cameras 
  • Microscopy systems including atomic force microscopy.
  • Spectographs
  • Magnetic resonance
  • Nano analysis tools
  • X-ray and electron analysis 
  • Etching and deposition processes

These may seem rather mindboggling but they begin to make sense when you take the time to understand what they do and what markets they serve.

Here is the breakdown of Oxford Insruments’ key end markets in the year to March 2020. The company sells to academic and commercial customers, which accounted for 52 per cent and 48 per cent of revenue, respectively, last year.

The company’s biggest end market is semiconductors. While the more commoditised end of this market has been volatile, there are good growth prospects for compound semiconductors used in new technologies such as electric vehicles and data capacity and bandwidths associated with new communications infrastructure. Oxford’s etching and deposition processes are used in a range of semiconductor devices, materials and applications. It is a leading player in semiconductors that improve the data speed, capacity and energy efficiency of devices. Its image and analysis solutions are helping customers to develop the next generation of smaller silicon semiconductor devices.

In the area of advanced materials, the company’s products help customers determine the characteristics and structure of materials so that they can be developed to become lighter and stronger and therefore perform better. This helps with the move towards things such as safer and more efficient cars and aeroplanes, better battery storage and low raw material usage in manufacturing.

The company’s benchtop analysers are a key product serving the energy and environmental sectors. Based on magnetic resonance technology, they are used to measure things such as nutritional content, and the content of oil, water, fluorine and fats in the food, agriculture, oil and chemicals industries.

Scientific cameras and microscopy systems are used in the study of diseases and in areas such as gene sequencing as customers try to understand how to develop treatments for medical conditions.

Quantum technology is seen in areas such as computing, communications and medical applications. Oxford’s quantum sensors are used by customers in these areas.

The company itself is very research intensive and spends a lot of money developing new products. It has a very high level of R&D expenditure compared with revenues, which is a source of competitive strength and a significant barrier to entry. 39 per cent of the company’s revenues came from products introduced during the past three years in the past year.

The company gets most of its revenues from overseas, with only 4 per cent coming from UK customers last year. The US and China are its biggest end markets.

Business performance

All these products sound very impressive, but what investors need to know is how much money can be made out of them.

The company is split into three different businesses.

  • Materials and characterisation. This includes the imaging and analysis of materials with products used in electron, ion and atomic force microscopes and the etching and deposition processes used in semiconductors. 55 per cent of sales come from commercial customers with the remainder from academic customers.
  • Research and discovery. This includes cameras, scientific instruments, cryogenics and high-magnetic-field platforms used in imaging and analytical measuring applications. 65 per cent of the sales here come from academic customers. 
  • Servicing and healthcare. This involves maintenance and service contracts, repairs, training and spare parts related to the company’s own products, along with the service of third-party MRI scanners in Japan and the residual healthcare business.

 

Oxford Instruments: Segmental business performance

£m

2017

2018

2019

2020

Revenue:

 

 

 

 

Materials & characterisation

105.7

118.1

137.9

137.8

Research & discovery

125.2

112

125.2

126

Services & healthcare

69.3

66.8

50.9

53.8

Total revenue

300.2

296.9

314

317.6

 

 

 

 

 

Operating profit:

 

 

 

 

Materials & characterisation

12.2

20.1

21.2

21

Research & discovery

13.8

13.8

12.9

14.5

Services & healthcare

12

12.6

13.6

15

Total operating profit

38

46.5

47.7

50.5

 

 

 

 

 

Profit margins:

 

 

 

 

Materials & characterisation

11.54%

17.02%

15.37%

15.24%

Research & discovery

11.02%

12.32%

10.30%

11.51%

Services & healthcare

17.32%

18.86%

26.72%

27.88%

Total operating margin

12.66%

15.66%

15.19%

15.90%

Source: Oxford Instruments/Investors Chronicle

 

Profitability has been on the rise in recent years and margins have also been improving. Despite the disruption caused by Covid-19, adjusted operating profits increased in 2020. The company has adopted a business strategy called Horizon, which is based on a better understanding of its customers and markets, as well as operational improvements, which are behind the improved operating margins.

It’s always good to see a company with a sizeable aftermarket business in servicing and spare parts as not only do these tend to be very profitable but they are also a key driver of customer retention and goodwill. Profit margins in this area have improved significantly since 2018.

The company is also playing closer attention to business returns and focusing its R&D efforts on the most profitable products. This has seen it sell out of businesses in recent years, as well as making acquisitions.

As far as the key driver of revenue generation is concerned, things have been going reasonably well. Orders received have tracked revenues well (often referred to as the book-to-bill ratio) while Covid-19 saw a build-up of orders at the end of March 2020.

 

Oxford Instruments: Order book versus revenues

£m

2016

2017

2018

2019

2020

Orders received

361.6

300.2

296.9

333.6

317.4

Revenue

380.8

298

313

335.1

336

Book-to-bill ratio

1.05

0.99

1.05

1.00

1.06

Closing order book

140.4

127.6

134

153.2

175

as % of revenue

38.8%

42.5%

45.1%

45.9%

55.1%

Source:Oxford Instruments/Investors Chronicle

 

Key financial analysis points

The company is reasonably profitable with decent operating margins and returns on capital. The returns on operating capital employed (ROOCE) – which exclude goodwill paid on acquisitions – are very good.

 

Oxford Instruments £m

2016

2017

2018

2019

2020

Revenue

361.6

300.2

296.9

333.6

317.4

Gross profit

161.9

157.3

150.9

159.3

158.8

Operating profit

44.6

38.0

46.5

47.7

50.5

Profit after tax

27.8

28.0

31.8

37.1

39.7

Capital employed

333.7

299.7

243.1

253.6

300.1

Operating capital employed

223.6

215.2

162.8

173.3

219.7

Capex

10.9

9.0

10.6

8.4

7.2

Free cash flow

29.6

24.5

19.9

35.7

48.0

Total debt

150.0

136.5

40.4

37.5

36.5

Cash

21.8

27.2

20.7

35.2

95.4

Dividend paid

7.6

7.4

7.4

7.6

8.2

 

 

 

 

 

 

Gross margin

44.8%

52.4%

50.8%

47.8%

50.0%

Operating margin

12.3%

12.7%

15.7%

14.3%

15.9%

Capital turnover

1.08

1.00

1.22

1.32

1.06

ROCE

13.4%

12.7%

19.1%

18.8%

16.8%

ROOCE

19.9%

17.7%

28.6%

27.5%

23.0%

FCF margin

8.2%

8.2%

6.7%

10.7%

15.1%

FCF conv

106.5%

87.5%

62.6%

96.2%

120.9%

Debt to FCF

506.8%

557.1%

203.0%

105.0%

76.0%

Div & BB as % of FCF

25.7%

30.2%

37.2%

21.3%

17.1%

Capex to sales

3.0%

3.0%

3.6%

2.5%

2.3%

Source: Oxford Instruments/Investors Chronicle

 

There has also been a marked improvement in free cash flow (FCF) generation since 2018, which has seen FCF margins improve significantly. Investment requirements in this business are low as most of the R&D spend is expensed against revenues, but the company has made significant improvements in cash collection from customers and reduced its working capital requirements.

 

Oxford Instruments: Working capital

£m

2016

2017

2018

2019

2020

Stocks

61.1

53.9

45.9

60.8

58.8

Receivables

77.5

81.1

73.3

78.3

71.1

Payables

-102.4

-93

-85.5

-116.9

-125.1

Net working capital

36.2

42

33.7

22.2

4.8

 

 

 

 

 

 

Revenues

361.6

300.2

296.9

333.6

317.4

as % of revenues

 

 

 

 

 

Stocks

16.9%

18.0%

15.5%

18.2%

18.5%

Receivables

21.4%

27.0%

24.7%

23.5%

22.4%

Payables

-28.3%

-31.0%

-28.8%

-35.0%

-39.4%

Net working capital

10.0%

14.0%

11.4%

6.7%

1.5%

Source: Oxford Instruments/Investors Chronicle

 

Receivables as a percentage of revenues have come down a lot since 2017 while payables have increased. This resulted in the company having an almost negligible net working capital position at the end of March 2020. It is also worth noting that there has been a considerable increase in customer deposits since 2016, which in themselves have seen a £17m annual improvement in operating cash flow since then.

Business disposals left the company with a net cash position (including rented assets) at the end of March 2020.

 

Turbulent medium-term outlook but good long-term growth potential

Covid-19 has knocked a big hole in the company’s near-term profitability. With universities across the world closed, many orders have been put on the back burner and commercial demand has also taken a severe hit. 

Despite a strong balance sheet, the company abandoned its final dividend last year as a precautionary measure. Predicting the future profits of most businesses in the current environment is very difficult. For what it’s worth, City analysts currently don’t expect Oxford Instruments to be back to 2020 levels of profitability until 2023.

 

Oxford Instruments: forecasts

Year(£m)

2021

2022

2023

Turnover

293.6

312

324.9

Ebitda

48.4

55.2

58.9

Ebit

37.8

45.7

51.3

Pre-tax profit

36.4

43.5

47.5

Post-tax profit

30.2

35.1

40.1

EPS (p)

50.5

59.4

65

Dividend (p)

12.9

15.2

16.3

Capex

9.9

10.6

7

Free cash flow

18.4

25.3

28

Net borrowing

-77

-89.3

-114.7

Source: SharePad

 

That said, I think there’s a lot to like about this business and the markets it is selling its products into. Assuming the world gets back to something near to what it was in the next few years I still think the trends towards electric vehicles, improved data connectivity, better battery lives, lower material usage and disease prevention are all very well underpinned and with them the longer-term outlook for Oxford Instruments’ revenues, profits and cash flows.

At 1,446p, the shares do not look cheap on nearly 27 times forecast depressed earnings, but look better value at 20.8 times last year’s earnings per share (EPS) Using this as a benchmark to value the shares, I can see the attraction for longer-term investors for what to me looks like a very high-quality business.