Judges Scientific: A fine example of buy and build

Companies that grow by acquisition are often treated with suspicion. This is no bad thing given the numerous corporate disasters that have come from acquisitions that have gone wrong. It doesn’t have to be this way. Halma (HLMA), Diploma (DPLM) and Bunzl (BNZL) have shown that a combination of acquisitions that do not stretch a company operationally or financially, while showing that their existing businesses can still grow is a recipe for long-term success.

I think Judges Scientific can be added to the list of successful acquirers. Its strategy and approach to buying is to be admired but there are grounds for thinking that this might have to change it slightly going forward.

As well as buying, the company has been equally good, if not better, at building the businesses it has bought. Its companies are supported by good fundamentals which are being temporarily held back by Covid-19.

Unsurprisingly, its shares are richly valued by the stock market and investors clearly expect continued impressive rates of growth. I am going to take a closer look at the company and its business to see if those expectations are realistic.

The business

In many ways, Judges reminds me a lot of Halma in terms of how it has developed. In the early 1970s, Halma began buying electrical engineering businesses, but instead of consolidating them it left them alone to operate as autonomous companies with minimal interference and help as it was needed. The company is now a member of the FTSE 100 with a market capitalisation of nearly £10bn.

Judges started by buying its first scientific instrument companies in 2005 and has since bought a further 18 which are spread across a diverse range of scientific research applications.

• Measurement systems for single fibres and filaments used in the hair care industry and the development of fibre composite materials.
• Advanced imaging systems used in neuroscience research
• Gas purifiers for metals analysis
• Edge welded metal bellows used in areas such as semiconductor and petrochemical  processing
• Instruments for electron microscopy sample preparation which is used extensively in scientific research
• Equipment and software for the testing of soils and rocks
• Illumination systems for microscopy which are a replacement for mercury based lamps,
• Fire testing instruments
• Academic teaching equipment, research and development systems and processing lines.
• Instruments which heat and cool materials used in an ultra high vacuum environment.
• Cryogenic devices which use nitrogen and helium for low temperature research.
• Vacuum deposition products used in the production of high quality metals for technology applications.
• Sheet metal work laser cutting and CNC machining used in making metal and plastic manufactured products.
• The measurement of  the thermal properties of lithium batteries.
• Instruments that measure the physical properties of optical fibres and cables.

The biggest proportion of its sales are to university research departments but it also sell significant amounts to industrial and commercial companies.

The vast majority of its products are world leading and niche in nature. I am a big fan of niche manufacturing companies as while they may not be selling into huge end markets, their bespoke nature and value added to the end customer often makes them hard to compete with. 

Profit margins can be very attractive and if a company can grow then very valuable businesses can be created. Companies such as Renishaw, and Fenner’s Advanced Engineered Products business are good examples of this. I think Judges’ business have these characteristics too.

The companies make money from the following sources:

Scientific instrument machines and software

• Spare parts
• Services
• Extended warranties
• Maintenance contracts

The bulk of its revenues come from selling quite expensive bits of equipment which can cost anything in the range of £5,000 to £200,000 each. Purchases of equipment are lumpy as they have lifespans of 10-20 years which means that the replacement cycle is long and that significant revenue growth needs to come from selling more to existing and new customers.

Visibility on revenues is quite short with order intake levels typically accounting for around 11-15 weeks of the company’s budgeted annual revenues,

University customer demand is determined by the availability of funding and tends to be less cyclical than demand from industrial customers where products are part of the capital expenditure budget which can get chopped in a recession as has been seen in 2020.

Judges is a global business with over 85 per cent of its revenues derived from exports. The company has been a big beneficiary of the devaluation of the pound since June 2016, which has significantly improved the price competitiveness of its products on overseas markets.

Business performance

A close look at the company's financial performance shows that Judges is a very good business. It has high profit margins, high returns and capital is good at converting its net profits into free cash flow.

Its acquisitions have been funded by its retained profits and borrowings without having to issue new shares. Its return on capital was 34 per cent before Covid-19 appeared and was still 24 per cent in the year to June 2020. 

Note that my definition of ROCE is slightly different to Judges’ explained in its annual report. I include cash in capital invested and add back short term debt but it includes unamortised intangible assets which I see the logic of given that the profit number used in the calculation ignores it. This is something I will consider in my own ROCE calculations going forward. My ROCE for 2019 was 35 per cent compared with the company’s 31.4 per cent.

Either way, the message is clear: Judges generates very good returns for its investors. 

One important thing to understand about the company is that it has a very high fixed cost base. This means that it has substantial operational gearing which means that the percentage  changes in profits tend to be bigger than the percentage changes in revenues. This is great when revenues are growing but not so good in a recession when revenues are falling.

The company splits its reporting of its business into two segments. There is very little specific discussion about them in the annual reports and this is something that I’d like it to improve upon. 

The Vacuum business is the biggest revenue and profit generators and has been doing better than Materials Sciences in recent years with not much growth coming from the latter.

Apart from temporary reduction in demand and production problems in 2016, the margin improvement from the Vacuum business has been very impressive, driven by acquisitions and operating leverage.

A closer look at the acquisition strategy

Judges are definitely not acquisition junkies who move from one new business to the next, integrating and cutting costs in order to meet short-term EPS targets. The complete opposite in fact.

The company’s approach to acquisitions is very measured in my view and shows it in a good light with a very attractive business culture. It wants the companies it buys to be long-term partners and this means treating the sellers with the utmost respect right from the beginning of the acquisition process.

Judges seeks to buy companies with the following characteristics:

• World leading and niche products
• Technological moats that make them hard to compete with
• High profit margins
• Sustainable revenues and profits with the potential to grow.
• Can be bought for single-digit EV/EBIT multiple. 3-6x has been the benchmark in the past.

The company takes its time to make acquisitions and only buys those in markets that it already knows. Its dealflow comes almost exclusively from the UK where it looks to buy from retiring owner sellers.

By nature the acquisitions tend to be very very small and rarely bring more than £1m to £2m of acquired annual operating profits. Of around 2,000 companies in its potential acquisition space in the UK  Judges reckons that around 100 are candidates for purchase over the next few years. It therefore seems that there will be enough dealflow to keep the acquisitions coming.

Judges act as a partner and leave existing management in place to run their business as they see fit (like Halma). Funds are made available by Judges to invest in new product R&D and grow the business. Judges is a long term owner and has not sold any of the businesses it has bought since 2005. It should definitely not be confused with a private equity company.

What is also very reassuring is that the acquisitions have not been big enough to put the company’s financial health at risk. They have also not been small and remote which could have caused issues if there was a subsequent problem with an acquisition.

If we look at the businesses bought the earnings before interest and tax (Ebit) multiples have been low and the starting return on investment (ROI) therefore very high. I have adjusted for excess working capital cash payments and earn-outs on purchase costs where possible in the tables.

These are the kind of acquisition prices and starting returns that most companies can only dream of and they have created significant value for shareholders with ROI far ahead of Judges’ cost of capital. Earnings per share enhancement is also a given at these kinds of prices in the current low interest rate environment.

Can it keep doing this?  An obvious question is why owners sell out for such a low multiple of profits. Sure, there is a small and private company discount while lack of finance may constrain their ability to grow.

But Judges paying six times Ebit for a company whose profitable peers are valued at 26 times Ebit on the current stock market must surely make future acquisitions at low multiples much more difficult. Some savvy sellers might try to exploit this. 

Recent comments by the chief executive on this issue suggest that businesses in Europe, and especially in the US, want higher prices and that the company has lost deals because others were willing to pay a higher price.

This could become a problem for Judges going forward. Low interest rates have seen valuation multiples of most businesses increase. There is also the possibility that the scale of acquisitions may need to become bigger in order to have a sufficient impact on the company’s overall profits. This could bring it into competition with more buyers and push the price up and lower returns.

That said, it has still managed to make what looks like a very good deal in 2020 with Heath Scientific in 2020 in the attractive business area of lithium batteries. The pace of acquisitions generally has been slower in recent times compared with 2015 and 2016 but Covid-19 and its aftermath could see owners wanting to sell out in the next couple of years.

Organic grows shows that Judges has bought well and builds value

Acquisitions are only one half of Judges’ business strategy. The other bit has been on building up what it has bought. Here, the results have been very encouraging with a very good long-term track record of organic revenue growth. 

2016 is perhaps the only recent blip on the company’s acquisition record while 2020 should be a warning to investors that the business is not bulletproof by any means. Organic growth has undoubtedly been assisted by a weaker pound in recent years but the company has also played its part with how it has helped its individual companies to grow. This is the proof that it is a very good business which acquisitions complement rather than being the sole driver of profits.

Judges’ businesses are supported by the long-term growth in academic research and the constant striving for improvements in research by businesses. Product development has also played a major part in Judges’ success.

For manufacturing products companies, research and development (R&D) of around 5 per cent of annual revenues is seen as a good benchmark. Judges’ meets this comfortably with rising levels of expenditure in recent years. Despite a recession, the company has not cut its R&D budget in 2020 which bodes well for future product development and revenue growth.

Outlook and valuation

Covid-19 has hurt Judges. Universities have been closed and there has been no travel to scientific conferences to win new business. Company capex budgets have been frozen or slashed. This backdrop has been reflected in Judges’ order intake and organic sales in 2020 growth with a significant decline, especially in North America but the UK,China and the rest of the world have held up quite well.

Judges reckon that the order and sales have been deferred rather than postponed. However, when they come back is far from certain.

The company has done a good job of taking reducing the operational gearing impact on its profits in the first half of 2020. It said that profits could have fallen by a third but the damage was restricted to a still painful 22 per cent.

Last month the company issued a very reassuring trading update for the year to December 2020, which showed that business conditions were showing some signs of not getting any worse. Organic order intake was down 17 per cent in the first half of 2020 but the decline moderated to be down 13 per cent at the end of 2020. This was enough for the company to say that it was confident of beating analysts’ forecasts for adjusted EPS of 151.8p at the time

In recent years, the company has benefited from research and development tax credits which have given it a relatively low tax rate of just under 15 per cent on its adjusted pre-tax profits. Now that it has over 500 full time employees it will lose that but will still be able to claim R&D expenditure credits at a lower rate. This means that its tax rate will rise but from what I can see there is no risk to forecasts from this as analysts’ EPS estimates seem to imply a tax rate of around 20 per cent going forward.

I think it’s reasonable to assume that this business will recover and start growing again but current expectations are for 2019’s operating profits not to be matched until 2022 with a strong recovery expected this year.

At 6,390p, the shares are not cheap on a one year rolling forecast PE of 33.7 times. This will be too expensive for some investors but for those who share the patient long-term perspective of its management, an investment in this very good company may still prove to be rewarding.