Description

As many stocks trade at all time highs, are any of them still sensible buys?  Judges Scientific is a UK (AIM) listed buy-and-build company in the scientific instruments sector with two ways of growing into an apparently rich absolute valuation.  Organic growth has been a robust, if lumpy, 7% as scientific measurement, testing and research continues to demand benchmark equipment; plus reinvestment into acquisitions of global niche companies at low valuations.  Written-up very well by Griffin less than 4 years ago at one fourth of the current price, the stock has compounded at 25% annually for 17 years since listing; so I do not claim that this is either super cheap or an undiscovered gem.  Instead, decent succession planning plus an external tax environment that tilts the probabilities to more and better acquisitions during 2020-22 should mean that significant shareholder value creation continues for a bit longer.

Valuation

2019 free cash flow was £14.7 million; 12 months ending June 2020 was £12.9 million (28.7x P/FCF); and 2019 pro-forma for subsequent acquisitions would be £16.9 million (22x P/FCF). 

Near term earnings could be quite weak, due to the pandemic’s travel restrictions reducing selling opportunities at scientific conferences and tradeshows and the installation of equipment at customers globally.

At the lowest of these free cash flows, the current valuation is fair value if they deploy future earnings at 15% ROIC, 8% WACC and generate 6% organic growth.  Not cheap, but not unreasonable for a company that since 2005 has deployed 90% of cumulative cash flow to acquisitions, and comfortably beaten these hurdles.  High return on capital businesses enjoying organic growth with reinvestment opportunities currently trade much richer.

Downside valuation scenarios

Intrinsic value degrades if, from most probable to least:

A. Judges cannot deploy capital at attractive valuations. 

a. 18 acquisitions at a median deal size of $4 million over the past 15 years have ranged 3-7x EV/EBIT.  In contrast with public markets, valuations of these tiny private companies have not significantly increased during the past decade. 

This is consistent with broader data in the US that shows a 6.0x median purchase price/EBITDA for the most recent year of 2018-19, unchanged from the average search fund acquisition multiple for similarly small companies during the whole period 2006-2019: 

b. Management appears disciplined on valuation, preferring to return cash flows to shareholders rather than overpaying, as demonstrated by the November 2019 special dividend.  

c. But as annual deployment capacity hits $20 million, at some point it is inevitable that decreasing proportions of free cash flow get reinvested, unless either deal size or deal frequency increases.  Judges acknowledge increased competition from other buyers for companies earning more than £1 million.  Only 3 of their acquisitions to date have exceeded that threshold, and 2 were disasters.  The old rules of capitalism still apply to these micro-acquisitions: the best returns are earned in the absence of competition.

B. Organic growth rates slow to zero. 

C. Operating business quality mean reverts, cutting ROIC to 8%. 

Any of these independent scenarios drop the valuation in half.  Of course discount rates might one day go up but…

Beyond hoping for the persistence of each of the company’s strengths (high reinvestment, organic growth and returns on capital), which does not seem crazy, the biggest defense comes from the 11% stake valued at $54 million owned by founder CEO David Cicurel (71).  This appears the dominant part of his personal wealth and far exceeds his cumulative compensation.  A plausible exit for him would be selling the company to any one of the global scientific instrument companies currently also trading at all time highs and richer valuations than Judges’.

Buy-and-build models that are not built carefully typically collapse at some point.  David Cicurel’s main strategies to avoid this fate seem to be decentralization and hiring well.  I am impressed with COO Mark Lavelle (62) who joined in 2017 from Halma, a model for Judges, who have been acquiring niche companies globally and managing them in a decentralized structure for much longer.  Several of the operating managers of the acquired companies have done a great job before and after joining Judges.  Of these, a few could step up as successors to either CEO or COO role, but the CEO has been explicit that he has no plans to retire yet.  Happy to discuss more in Q&A.

Managing adverse selection: the key to sustained upside

Public market investors easily underestimate the power of adverse selection.  The skill set of public investors requires turning Mr Market off, because the entire public universe is available all day, every day.  Private markets function differently, with businesses only rarely being available for sale, so the investor must wait for Mr Private Market to turn on.  But private business owners often get to choose when they sell, which would be the worst time to buy.  The skill of private investors therefore is to avoid adverse selection.

The starting point for doing this is building a reputation of integrity and professionalism, so legacy-minded founders seek to sell to Judges.  But this company is not unique in this approach.  Beyond consistently trying to do the right thing, adverse selection can be reduced in these type of acquisitions in four main ways:

1. Circle of competence is required to prevent asymmetries of information about the technology and competitive environment that will shape future earnings.  Here, odds of successful acquisitions improve with scale, since Judges has more operating managers with deep expertise in the science of an acquisition candidate. 

2. Due diligence to detect signs of peak earnings. 

3. Management in place; people issues.  It is easy as a public market investor starved of cheap stocks to overestimate the attraction of tiny private companies available at 3-7x EBIT.  Many of these depend entirely on the founder.  Sometimes adequate replacements cannot be recruited who combine commercial instincts with sufficient depth of scientific knowledge.  Or not at the company’s location, which can be idiosyncratic to the founder.  Judges should improve at solving this problem as it scales, in certain cases already lending an operating manager to another sub part time during succession.  But without solving any management gap, what looks cheap invariably proves very expensive.  Usually the best acquisitions will have succession already taken care of, or sometimes the transaction is catalyzed by just one retiring founder, with the others remaining in the business.

Judges has made mistakes.  The two biggest in my opinion would be Scientifica and Armfield, unfortunately both relatively big acquisitions ($16 and 13 million). 

1. Circle of competence: They did not fit any existing deep expertise within the group.

2. Due diligence: came up for sale after a period of unusual growth in sales (Scientifica’s 31% 5 year CAGR prior to acquisition moderated to 5% after) or margins (Armfield’s 14% margins at 2015 acquisition continued for one year before reverting to its typical 3% margins which had been delivered 2000-09).

3. People: maybe this was impossible to discern at the time, but with the benefit of hindsight, buying from two young founders who were selling for no obvious reason other than an insider’s knowledge of the optimal time to sell / worst time to buy (Scientfica); and from sellers who were not founders, but MBO veterans familiar with their business’ cyclicality (Armfield) did nothing to reduce adverse selection.  Just as decent auditors design tests to prevent management manipulating financial statements, decent acquirers of scientific instrument businesses with long lead times (equipment sold for university research can last for 20 years with zero consumables or service sales) who could temporarily overcharge or underinvest, need to test whether a seller is focused on finding a home for their life’s work, or merely getting rich.  As the great man says: “If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy.” 

After 18 acquisitions over 15 years, management has increased its data set of what to avoid, but also what to seek out.  Some of its positive experiences:

1. Circle of competence: When the CEO acquired his first scientific instrument company in 2005, he had no real circle of competence in the business of Fire Testing Technology, (the globally dominant manufacturer of fire testing equipment used to monitor compliance with legislation), despite only costing $5 million.  Nevertheless, he got lucky.  15 years later, the operating manager of that sub has a PhD in this field, which facilitates acquisitions like Heath Scientific earlier this year, because it shares similar scientific fundamentals.  (Heath specializes in the design, manufacture and sale of instruments used to measure the thermal properties of lithium batteries and other reactive materials. Its main product, the Accelerating Rate Calorimeter, is a key tool to improve and verify the safety of lithium batteries and of other chemical reactions. This is an expanding market in light of the growth in the use of lithium batteries in electronic devices and electric vehicles.)

2. Due diligence: rejection of many unsuitable candidates.

3. People: Global Digital Systems (which designs, manufactures and sells instruments used to test the physical properties of soil and rocks. The products are sold worldwide to academic institutions and commercial customers conducting geotechnical research or providing testing services in relation to large civil engineering projects) has doubled sales 

since its 2012 acquisition, still delivers 20% pre-tax margins, and continues to be led by the two people who were hired, trained and appointed as successors many years prior to the sale by the two founders.  Judges reduced adverse selection by dealing with honorable founders, who had revealed their preference for maximizing the people strength of the business rather than personal financial gain at sale.  One founder’s wife was HR head.  The sellers acted like they were handing over the baby that they had nurtured for 33 years.  These are wonderful acquisitions to make. 

Previously I said there were four ways to reduce adverse selection.  The first three require management skill, and can be developed with experience.  The fourth is the easiest and most powerful:

4. Forced selling due to external factors.  

This is the equivalent of a stock market crash for value investors, when to some extent, the normal requirement to exhaustively research a company is reduced.  In the absence of company-specific problems creating one cheap valuation, the opportunity set is rich due to pervasive cheapness, meaning an investor can buy with reckless abandon.  During Judge’s history, one period when external factors dramatically reduced adverse selection was 2008-9 and its aftermath.  In 2008 they spent considerable time and money on due diligence of a Hong Kong based company which would have doubled their then size, but as David Cicurel later recalled: “But then our bank nearly went bust, so we didn’t have the money to do it.”  In that context, any founder of a tiny private company approaching retirement would no longer have the luxury of timing a sale at the ideal time for them, but instead try to sell when they can.

The acquisitions of Quorum in June 2009, Sircal in March 2010, Deben in March 2011, maybe even Global Development Systems in March 2012, could all be viewed in this light: adverse selection was materially reduced because the external environment favored buyers over sellers.  Just like most stocks bought in the market around March 2020 have likely performed well, most private scientific instrument businesses bought around that major economic dislocation a decade ago have also succeeded.

Below are my calculated annual pre-tax returns since acquisition assuming a constant 10% cost of equity.  (Growth capex and investments are not included).   

Quorum stands out as their best acquisition by far.  Both sales and margins have doubled since acquisition, so what was originally bought for just $2 million now contributes 25% of group EBIT.  That is the opposite of adverse selection.  Management has undoubtedly done a good job.  Valuation, at 3x EBIT, helped.  But valuation alone does not explain Quorum’s superior returns to businesses bought outside of this period of external stress.

The following chart removes the effect of valuation, by uniformly calculating the returns as if each acquisition had been executed at the highest valuation: 7x EV/EBIT.

Returns in the second chart are lower obviously, but the overall picture is unchanged: the best acquisitions were bought during a period when external factors reduced adverse selection.  The proportion of lemons on sale declined, as forced selling became widespread, so acquirers could expect to do better than during a normal period when they can only use their own skill to avoid potential disasters.

Why is this relevant now?

For only the second time in Judges’ history the external environment might be offering an opportunity. 

Firstly the pandemic’s challenges on managing small operating businesses might catalyze sales from founders that otherwise would be timed. 

Secondly, UK tax policy might be driving small private company sales.  Entrepreneur’s Relief, renamed Business Asset Disposal Relief, had previously levied a 10% personal tax rate on disposals of businesses up to $13 million in value: a significant relief compared to UK’s 45% highest income tax rate.   This was flagged for change in July 2019, and the maximum company value was reduced by 90% to $1.3 million in March 2020, above which 20% capital gains tax applies.  A Capital Gains tax review in November 2020 is being read by many UK entrepreneurs as signaling a probable future rise in this tax rate, potentially equalizing it with income tax rates, as taxes inevitably rise in future to finance current pandemic costs. 

In this context, how might the December 2019, $3 million acquisition of Moorfield Nanotechnology rate on adverse selection?  (Moorfield is a maker of coating instruments, specializing in the design and manufacture of physical and chemical vapour deposition instruments used to cover materials with thin films. Moorfield's systems are used for academic and industrial research, including semiconductors, photovoltaics, graphene and 2D materials.)

1. Circle of competence: acquired by Quorum, a world-leading manufacturer of instruments use to coat samples for electron microscopy.

2. Due diligence: historical financials not publicly available, so I have no insight on this.

3. People: the founding couple ran the business for 30 years, hired a decent 32 year-old PhD in 2014 as technical director, promoted him to Managing Director in 2017, and watched him run the business for 2 years before selling to Judges in anticipation of retirement.  Good signs.

4. External factors: the 10% tax rate paid by the founders on sale would have been 20% if Entrepreneur’s Relief had been removed entirely. 

Moorfield therefore has the ingredients of proving to be a very successful acquisition, since adverse selection has been significantly reduced by a combination of management skill and by an external environment that was favorable to the buyer. 

Who knows what actually happens to tax rates long term.  Conceivably it could also be a long term negative to Judges’ acquisition model, if in future founders derive no tax advantage from a sale compared to continuing to own the business as a non-executive and receiving an income into retirement.

However, currently UK founders can still sell their companies at 10-20% tax rates, compared to a feared 45% or higher if taxation rates there change.  This external factor alone might be sufficient to produce decent acquisition opportunities, of which some might already have been completed (3 acquisitions have been completed in the past 12 months for the highest deployment to date).  A few winners like Quorum could make up for several disappointments.

Further resources

Each operating business is presented by its manager: https://www.judges.uk.com/financial-performance/videos.html 

Tax references: https://www.gov.uk/government/publications/ots-capital-gains-tax-review-simplifying-by-design

Single historic currency conversion rate of 1.333 is used throughout.

Closing price of 57.40 in 56/59 spread.  59 ask price used in header valuation.

Catalyst

tax driven selling of attractive acquisition targets