Eureka Correspondence

Challenging SDI's buy call, Capitol Health, and CSL.

Challenging SDI’s buy call

I write with reference to the ‘buy’ recommendation for SDI (see Dental group still on growth path).

What I would like to comment on is the awful market position this company appears to have. The company appears to be significantly dependent upon the sales of amalgam, although the report acknowledges that this is a declining market. The composite market is the future and competition will be a lot more than being one of four.

Of the four main directors the only person with experience of the business appears to be the founder, Jeffery Cheetham, who is 70 and is limited to a high school education. Alongside is his wife, an accountant and his daughter who is qualified in banking and finance and holds an MBA. There are four non execs: one legal, one investor relations and two retired (over 65) experienced businessmen.

This would appear to be an ageing board at a time of a serious threat to core business. Moreover, the planned successor, Samantha Cheetham, appears to have no fundamental experience of the development of chemical products in the way her father has.

I also note that the earnings of the three family directors were significant, typical of family owned companies in my experience.

My conclusion is therefore that by being family owned, being in a situation of the company’s main product being in decline, and by having an ageing board with no real succession plans apparent, that this is a ‘buy’ recommendation with extraordinarily high risk. I certainly will not be investing in the stock.

Ron Bone

Simon Dumaresq’s response: Thanks for your letter. I was referring to the glass ionomer market when I was talking about SDI being one of four manufacturers. This now represents a meaningful 15% of company earnings and SDI is well placed in relation to competitors.

In regards to the composites market, there are definitely more than four competitors, and it is dominated by diversified technology company 3M. The challenge here is to develop relevant products that dentists will choose over competing products.

Demand for amalgam is declining in developed nations, but it remains stable in third world countries. The company has shifted its marketing efforts to these countries for amalgam.

It is true Jeffery Cheetham has no post-grad education, but I think 42 years of industry experience adequately compensates for this shortcoming.

Further, whatever technical experience or formal education is lacking within the board is compensated by a highly qualified and experienced team of scientists and chemists.

Samantha Cheetham has over 20 years of experience in most parts of the business, and there has been a very long succession plan in place. When Samantha takes over as chief executive, Jeffery will remain chairman and will spend more of his time with the development of products.

However, I do see an issue that there could be better non-family candidates out there who are not getting a chance to apply for the position.

The $1.3 million payment to the three family directors is not excessive considering their role in the business, and the combined director payments of $1.9 million compares well with other companies of similar size and performance.

The largest risk in my opinion is any large unhedged increase in the silver price as well as the Australian dollar – with moves to the downside presenting a potential positive catalyst.

The company is cheap, but I agree it is high risk, and doesn’t make the list of my top five companies to benefit from reporting season in August.

Behind Capitol Health’s valuation

Would it be possible for Simon to help out with his valuation on Capitol Health (see Capitol gets healthy diagnosis)? From my figures the company’s cash ratio is 0.5 times with a poor profit margin of 5.8%. I am hoping to gain some of his insights and make it into an educational opportunity for me.

It would be great to see an interview of your latest recommendation, SDI, which I believed was a great call! Its net tangible assets (NTA) are 44 cents, which, minus intangibles, goes down to 38 cents! That sounds like a big bargain hands down.

Ian Fok

Simon Dumaresq’s response: Thanks for the letter. The reported cash ratio is misleading if you don’t remove the employee leave entitlements from the current payables figure. The trade receivables and trade payables are both around $1.5 million. However, there are other accruals and liabilities for annual leave which is included in the reported “trade and other payables”.

Further to this, with a cash balance approaching $10 million, and minimal working capital drag, we don’t see any short-term liquidity risks.

The net margin of 5.8% will improve in years to come from the benefits of increased scale and utilisation.

Behind CSL’s gearing lift

Thanks for the recent article on CSL (see CSL returning to value). I have a high proportion of my SMSF in cash, and am keeping a watch list for bargains when they eventually arise.

I greatly like the look of CSL, but am wondering about the recent high increase in debt to around $2 billion. I tried searching in your field but CSL did not appear. Can someone enlighten me in regards to CSL’s debt increase?

PC

StocksInValue’s response: CSL’s gearing has increased in recent years due to an “efficient capital management” program in place since 2005, by way of a share buyback scheme. The company’s objectives when managing capital are to safeguard its ability to continue as a going concern whilst providing returns to shareholders and benefits to other stakeholders. This has seen expensive equity replaced by cheap debt (shares bought back using borrowed money), and was timely in recent years because money has been historically cheap. As an example, in a funding arrangement in 2013 CSL was able to borrow $500 million at an average rate of 2.81% with an average duration of 8.5 years.

The share buy-back improves return on equity (ROE), earnings per share (EPS) and dividend per share (DPS) – and thus total returns to shareholders.

Net debt to equity (gearing) increased from 0% in 2009 to 33% at the latest half year result. As a result our rating of financial health has declined very slightly from 8 to 7.5 stars as the overall lift in debt relative to other financial metrics hasn’t compromised financial health. The company aims for a capital structure with a prudent proportion of debt funding to reduce the cost of capital without adversely affecting credit ratings.

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