This document is intended to be read in conjunction with the 31st March 2015 preliminary results and the company’s investor presentation available from; www.acal.co.uk/acal/uploads/presentations/Acal-plc-Year-end-results-FY15.pdf
It is only intended as some background on the business and its market and a reflection on the main themes raised by Management in the Investor presentation on the 4th June 2015 which I attended.
The Business
Acal describes itself as an industrial electronics company. Historically Acal was a franchised distributor of electronic components but current management have been moving it into higher margin design and self manufacturing.
Market and background
Electronics has been a relative growth area since the 1960’s. Whilst market growth rates are no longer double digit Acal’s management quote a rate of 4 times GDP as an expectation of potential growth in any market with currently a potential for significant upside from the move to the “internet of things”.
There are many variations of electronic component distributor but at their core they almost all provide a range of standard products from manufacturers and on top of these design products, usually in collaboration with the manufacturer, which are supplied as specials.
Customers by and large want standard product as it is cheaper, sourceable from other distributors, and generally has lower lead times. It can also often be replaced by another manufacturer. Distributors and manufacturers want specials for the opposite side of all the same reasons.
In both cases the real profit is in getting the component designed into a product that is then in production for some years.
The development of Acal under current management is two fold;
1 – They are placing a high emphasis on the design side of the business – “Specials” and have sought out franchises that lend themselves to customisation.
2 – They have made very significant investments in directly acquiring manufacturing businesses in various sectors.
In many ways Acal’s evolution is a copy of the model XP Power Plc has used. DISTRIBUTION to DESIGN to MANUFACTURE. Though XP is focused on power supplies only.
The big advantage of the new model is that in the new sectors gross margins are significantly higher than the old business. 40-45% from 30 – 35%. Management discussed Operating Margin levels in excess of 11% from a current level of below 5%.
Current Situation
The impression I have is that management are keen to portray Acal as a business under real change and I would broadly concur with this. However I do not think it is as clear cut as is being suggested.
There is an emphasis on design work, but this is more a refinement of the previous strategy than a new strategy. Though there does seem to be progress on finding franchises that lend themselves to design in.
What is new is the very significant emphasis on manufacturing. Well over 40% of the market capitalisation reflects businesses acquired as part of the manufacturing strategy.
A low risk approach
In the presentation I attended management took the opportunity to suggest that Acal is a low risk business for a number of reasons.
1 - Questions were asked about R&D costs in the company and the response was that Acal does not do much Research. There is a little in the manufacturing businesses but across the group Acal engineers are focussed on existing, widely utilised technologies. Sensors, Transformers, fibre optic, Bluetooth were all used as examples of Acal developing an existing product type to meet a defined customer need. Ie low risk development with a clear path to revenue. This is true on both the Distribution and Manufacturing side.
2 – With the electronic market place growing at 4 times GDP Acal should be able to get growth rates of 3 times without excess risk. At GDP growth of 1% that is only a 3% growth rate. But at 3% GDP growth a 9% rate could be envisaged.
3 – The largest customer is only 2% of revenue and the largest group of customers is only 3% of revenue. Top 10 customers are 11% of revenue and the top 100 34%.
4 – Acal supplies a diverse range of sectors with the largest being industrial at 20%. Medical is the next largest at 12%
5 – The group is diversifying internationally from its historic west European focus. It now does 11% outside Europe with positive growth in the US and Far East. I believe this is principally down to its manufacturing business as the US market is very competitive for distribution. I would also note that the old Acal had a significant Asian presence for many years but I believe this ended due to bad debts in the region.
6 – I would also add that the management team seems fairly stable and Nick Jeffries the CEO is very well regarded. As is Paul Neville the Group Commercial Director who I believe has a key role in acquisitions.
7 – Acquisitions are only being conducted at lower valuations than Acal itself. As such they are inherently value enhancing and the market remains fragmented so prices are not under pressure. After the main presentation in talks with attendees there did seem to be an acknowledgement that given the size of recent acquisitions and the fact they were in large part funded by a rights issue there is a need for management to demonstrate the success of these before another significant acquisition occurs. Not stated but implicit within this is that next years Statutory Accounts may have numbers more in line with the underlying performance figures used by Acal.
8 – A substantial part of the current business is the old distribution business. This is ongoing, profitable and can provide sales resource for the new manufacturing sections. This both improves profitability, lowers the cost of customer acquisition and derisks sales expansion.
Financials
The following chart sets out the basic figures as Acal would like to present them.
FY 2014 FY 2015 FY 2016 Fcast
Sales £211.6m £271.1m £305m
Operating Profit (1) £7.1m £13.4m £17.4m
PBT (1) £6.3m £11.8m £14.9M
(1) Due to the significant level of acquisitions last year there is a lot of exceptional costs in the 2015 accounts. Acal strips these out for presentation purposes, so I have for this chart. Readers are advised to refer directly to the accounts for a better understanding of treatments. (See point 7 above).
(2) Personally I am concerned by the number of non-IFRS measures Acal uses to validate its results.
(3) I also wonder why a company with an avowed acquisition strategy thinks it reasonable to call acquisition related costs exceptional.
I do understand why Acal likes to use these genuinely impressive numbers. I also accept that there is an underlying rationale for them. But that rationale only holds water if in pretty short order the IFRS numbers converge. IFRS PBT in 2014 was only £4.2m and in 2015 only £4.3m. In my opinion the jury is out on whether management is producing numbers that give a clear indication of an improving business or are flattering themselves.
Targeted Free Cash Flow is 75% of PBT and this is being achieved.
Concerns
1 - Design cycles are often longer with Specials and in manufacturing. A typical design cycle of 1 – 3 years was stated by management. This means that most of the acquired business and presumably the growth that is being discussed was started before Acal had control.
2 – In the presentation reference was made to various parts of the “new” business. Whilst many of them were clearly niche and presumably could be matched by only a few firms other seemed more open to competition.
3 – Manufacturing has higher margins than distribution. But it also has a range of different issues to address. Given the reasonably dramatic shift in Acal’s business in the last year there has to be a question as to how well Acal can run significant manufacturing businesses. I am not saying they cannot, just that the jury is out until they have been doing it for longer
4 – I am concerned when a company needs to provide reconciliations between the numbers it wants to use in its presentations and the statutory accounts.
5 – The UK results. The UK has historically been the largest part of Acal. However 2015 results show a significant fall in LFL UK revenue. This raises three concerns. (a) if Acal cannot prosper in its existing largest market will it really succeed elsewhere? (b) When Acal talks about increases in the % of revenue from non UK, how much of this is real growth and how much is just maths? If the UK declines you will automatically get relative growth elsewhere even if real growth is zero. (c) It is unclear to me how much of the decline was intentional, (it was stated that some franchises and customers were dropped), how much is market related ( Acal did try to suggest that the market had declined. But this does not tie to growth of 3* GDP. The UK had positive GDP), and how much is key senior management being focussed elsewhere and not properly running the existing business. Acal has some very good senior managers but could they be overstretched?
Other Items of interest
Management are incentivised through share options and when questioned on possible takeovers of Acal seemed more than willing for one to happen.
IFRS PBT in 2015 was £4.3m. This is after £4.9m of acquisition related expenses. If they do no acquisitions next year and all else being equal IFRS PBT more than doubles.
Final Thoughts
The last take away that the CEO – Nick Jeffries set out at the presentation was that Acal is seeking to be a solid growth company for many years to come. Being in electronics it can grow 3 – 4 times faster than GDP. With the change in model it can double its operating margin. As it is in a generally fragmented industry it has a long runway for both the organic and acquisition side of its business.
I find all of this genuinely persuasive as a strategy but have to admit that the jury is still out on the execution. I am a long term holder of Acal and will, based on the information I have, continue to be so. However the business has been changed dramatically in the last 18 months and the UK results do concern me. As such I do not intend to allow Acal to be more than 10% of my portfolio (my theoretical max on any share is 20%) until they have proven they can execute on the new model. If they do that I would reset my limit to 20%.
This document is an opinion piece only and every possible caveat and disclaimer applies. It is not my intention that anyone should take this as investment advice but it can provide a starting point for you to do your own research or to discuss with someone who knows what they are doing.