SAI's post-binge indigestion

SAI Global was dealt a good hand. When it was floated off from Standards Australia in 2003, it took with it exclusive rights to distribute Australian Standards, and rights to distribute ISO and IEC international standards.

This was lucrative enough, but it also gave SAI a way in to its customers to sell related services, such as training and certification, at a time when rules and red tape have been rapidly growing.

For many years SAI played its cards well, milking its core business and making judicious acquisitions. But in the past couple of years it has all unraveled. Net profit fell 5% in 2012 and will probably fall again this year. The share price is down 32% from the record high of $5.29 almost a year ago, and is now lower than it was six years ago.

It looks like a classic case of indigestion. In 2005, SAI figured (quite reasonably) that it could use its position to sell its customers compliance management software and it embarked on a acquisitive growth strategy. There were some worrying rumblings in 2007 (see our AGM update on 29 Oct 07 (Hold – $2.96)), but the company pressed on, culminating in the recent purchase of two US-based companies – Integrity Interactive for $170m in 2010 and Compliance 360 for $42m in 2011 – which lifted the Compliance division to about 20% of earnings before interest and tax.

Screw up

The result has been a large client base using a multitude of different software platforms. To reduce costs and provide better solutions, SAI decided to move clients on its existing Learning content platforms onto one new platform. Unfortunately, the actual outcome was higher costs and poorer solutions. Of around 70 customers that have moved to the new platform so far, about half are experiencing problems (about 5% of the total client base).

Problems are so severe that SAI has stopped moving clients across to the new platform altogether and is now looking for a different solution. The botched nature of this project suggests management inadequacies; the response to them only heightens this perception.

As late as last December, management claimed the problem was under control. The interim results in February revealed that it most certainly wasn’t. Either management didn’t know the extent of the problem or tried to hide it. Neither is reassuring.

Accountability seems to be lacking, too. At the interim results, chief executive Tony Scotton’s approach to the problem was very much in the manner of ‘the new platform has gone very poorly’. A more honest approach might have been, ‘we screwed it up’.

Statements like ‘The Group has continued to grow during the period...’, citing a revenue increase, when profit has fallen reinforce the sense that this is a management team lacking in candour, more concerned with the massaging of opinion than an accurate presentation of the relevant facts.

SAI Global remains an attractive, resilient business and we were hoping that these recent problems might have provoked a buying opportunity. Unfortunately, with the stock trading on a multiple of about 17 times this year’s forecast earnings, despite the share price tumble it’s not cheap enough.

If you add back some of the company's amortisation charge you can get the PER down a bit, but we're not inclined to allow much slack. The intangible assets are only amortised where they’re wearing out, so they’ll need to be replaced. And a fair slug of SAI’s ‘capital expenditure’ does indeed go on intangibles.

Cash flow problems

You can sidestep this issue by looking directly at free cash flow. Having fallen from a very healthy 100% or more of net profit to 89% in 2011 and 67% in 2012 (see Chart 2), it’s ringing its own alarm bells. Partly to blame is the jump in expenditure on the platform that now doesn’t work, and the efforts to deal with the issues.

When asked about capital expenditure in the Compliance division at the recent interim result, Scotton was somewhat dismissive: ‘We’re talking about a $90-95m business generating significant levels of profitability [and] capex relative to that is quite small’.

We think forecast capex of $12m for a business that made earnings before interest and tax of $14m last year is quite large. Forecast group capex of $28m compared with net profit guidance of $40.5m to $44m is also quite large, and it takes the free cash flow yield down to below 5%. That’s pretty mean for a company facing such serious problems.

We’ll be watching developments closely in the Compliance division but, as things stand, it looks like the market is getting this one just about right. We’d be looking to Buy below about $3 and Sell above $4.50, but for the time being HOLD.