Scanfil is a lovely little Finnish small cap business that is earning a stable ROIC of 15 %, is generating steady free cash flow, and is selling at conservatively stated book value or at about 60% of conservatively estimated intrinsic value in one year’s time.

A catalyst for unlocking the value has recently emerged: the company is restructuring its business into a fully owned subsidiary, which is going to recapitalize itself. In one year’s time the parent company is going to have excess cash of about 1.80 €/share, which could possibly be distributed to shareholders, or could be used in some other shareholder friendly fashion. In addition, the parent company is going to own the recapitalized business subsidiary which is going to be worth about 1.95 €/share, resulting in an intrinsic value of 3.75 €/share, while the stock is currently trading at 2.22 €/share. This valuation does not take into account any growth (which would be accretive to value) or any kind of possible takeover premium.

The downside risk of this investment is very limited, as the book value of 2.19 €/share is very firm, and I consider it as a floor to intrinsic value. If the gap between price and value is closed in one year, one will enjoy an annual return of 69 %.

Please note that all figures in this write-up are in euros, including the share price and the market-cap in the title.

Scanfil is a contract manufacturer and systems supplier for telecommunication and industrial electronics industries. Its largest customer is the Finnish mobile phone network giant, Nokia Siemens Networks. Its main telecommunication products are integrated enclosure systems for mobile phone and ADSL networks. Industrial electronics products include box-built tested devices, various electronic modules, backplanes and assembled circuit boards and cable assemblies.

Telecom products account for approximately 70 % of the firm’s revenues, and industrial electronics account for the rest. The industrial electronics sector is growing, whereas the telecom sector is expected to be stagnant. The company has production plants in China, Hungary, Estonia and Finland. In 2007, 39 % of sales were from the Chinese subsidiaries, and that percentage is growing, as production is moving to China. The company started production there in 1999.

The company is a family business, founded in 1976 by Jorma J. Takanen, the current chairman of the board. He worked as the CEO until 2005. The current CEO, Harri Takanen, is his son. The Takanen family and members of the board own about 60 % of the shares.

The company is run and financed very conservatively. The company hasn’t had any net debt for 5 years. The company has been paying a regular annual dividend for a long time. Its stated dividend policy is to pay out about 1/3 of profits to shareholders. The company has low expenses and very tight cost control. The annual reports are just one illustration of this: there are no fancy colours or any photos. The headquarters are not located in Helsinki, the capital of Finland, but instead in Sievi, a small rural town, next to production facilities. There are no executive options, and executive compensation is modest. In 2007, the new CEO earned 74,000 euros for 7.5 months of service. Jorma J. Takanen was paid 82,000 euros for his services on the board. The other board members received 18,000 euros per person per year. The company tends to be conservative in its estimates of the future. The company has been calling its results “satisfactory” and also expects its profitability to remain “satisfactory”. It is not giving out any guidance.

The company was listed on the Helsinki Stock Exchange in October 2002 through a reverse merger with Wecan Electronics, another small Finnish contract manufacturer and Nokia’s subcontractor, which was IPOed during the tech bubble of 2000. The shareholders of Scanfil received 86 % of the merged company. Because of this transaction, the financial statements of Scanfil prior to 2003 are not directly comparable, because the company was privately held at that time.

The company’s financial statements are easy to analyze. The business is very steady in terms of operating margin and return on invested capital. During the past 5 years, the average EBIT margin has been 8.1 %, average NOPAT (net operating profit after taxes) has been 6.0 %, and after-tax ROIC has been 14.8 %. The trailing 12 month figures are 8.9 %, 6.6 %, and 15.4 %, respectively, indicating that the current profitability is slightly above average.

To illustrate the stability of the business, the adjusted EBIT margins since Q1/2003 are shown below. The only adjustment to the reported numbers is for a write-down of 7.6 million euros in Q1/2006. The write-off was a result of closing Scanfil’s Belgian plant, which it bought from Alcatel in Q2/2003 for a very cheap price. During those 3 years, Scanfil moved the production to China and then closed down the plant. The write-down has been spread out evenly to the preceding 11 quarters, during which the Belgian plant was operating.

I have tabulated the financial results since the beginning of 2003 in the table below. This table also shows that the margins and returns on capital have been stable, even though sales haven’t been. The calculation of return on invested capital (ROIC) includes a goodwill of 2.5 million euros. The average return on tangible invested capital would be 15.2 % instead of 14.8 %.

I believe there are several reasons why the market is currently undervaluing Scanfil. I believe that the most important reason is that Scanfil has been lumped together with other contract manufacturers and suppliers to the telecom industry (especially to Nokia). Scanfil has always been very profitable, whereas many other suppliers have been turning in operating losses. The market seems to disregard this, and seems to treat all Nokia’s Finland-based suppliers as toxic waste.

In addition, the market has been scared about the declining revenues. The decline is a result of a couple of factors. In 2006, Nokia and other wireless network manufacturers moved to smaller modules, which require less work and less material, thus, less business for Scanfil. In 2007, the mobile phone network business was in turmoil, as many companies were undergoing mergers. In particular, Nokia Networks was merging with Siemens networks. What, however, is noteworthy, is that declining revenue has not materially affected Scanfil’s relative profitability. This an incredible testimony to the abilities of the management to scale the business and keep costs in line with revenues.

In addition, last year Scanfil was charged with a suspicion of possible breaching of the ongoing disclosure requirements and suspicion of misuse of insider information in turn of the year 2005-2006. The prosecutor pressed charges on the first suspicion, and demanded a fine of 25,000 euros. The District Court of Helsinki dismissed all the charges in January.

The market may also discount the shares of Scanfil because of high insider ownership. Because the company is a family business, it is not a likely takeover candidate.

At the end of February, the company announced that it is going to undergo a restructuring. In the beginning of May, the operating business and all operating assets and liabilities were transferred into a new subsidiary called Scanfil EMS. The new operating subsidiary is now all equity financed, with an equity ratio of about 85 % and no debt. The management’s target is an equity ratio of about 40 %, which implies a debt-to-equity ratio of about 1.1. The operating subsidiary is thus going to lever up its balance sheet by taking on new debt worth about 46 million euros (0.78 €/share), which is going to be returned to the holding company tax-free.

The official reason given to the restructuring was “to increase contract manufacturing business and invest retained earnings in new areas of business”. However, I believe that the language used in the announcement is intentionally somewhat vague and unspecific. The Finnish tax-code states that any transaction that is concluded only to avoid paying taxes can be by-passed by the tax authorities, and taxes can be levied as if the transaction did not take place. In this case, Scanfil’s restructuring enables it to distribute a special dividend and declare it as tax-free return of capital, instead of taxable dividend.

Furthermore, the company could potentially sell the whole operating subsidiary (possibly at a very nice premium), and that sale would be tax-free. A tax-free transaction is enabled by a fairly recent change in the Finnish tax-code, which allows a company to sell shares tax-free if those shares have been owned for more than two years.

Even though the restructuring announcement contains some language about possible diversification into other business areas, I think this language is only used to avoid taxes. I very much trust the management to either deploy their capital in shareholder-friendly fashion, or return it to them. So far, they have always exhibited rational behaviour.

While the current share price is 2.22 €, the company is trading at very low trailing 12 month multiples:

- EV/EBITDA: 3.4

- EV/EBIT: 4.5

- EV/NOPAT: 6.1

- P/E: 8.9

- P/B: 1.0

At the end of Q1/2008, the company had 55.3 million euros in cash. With 58.7 million shares outstanding, that makes 0.94 € per share in cash. Debt per share is 0.20 €. Assuming that 1% of sales is required to run the business, there is 0.70 €/share in excess net cash.

For the purpose of valuation, I start by discussing the book value or reproduction value of Scanfil’s assets. Then, I do a simple valuation without considering the forthcoming recapitalization, after which I look at the value after the recapitalization. Finally, I consider the value of possible growth.

The book value of the company is stated very conservatively. No expenses are capitalized, and there is little goodwill on the balance sheet. During the past few years, the company has sold some production plants in Finland and in Belgium, and all the assets have been sold at prices above their book values. If a competitor wanted to reproduce Scanfil’s assets, it would need to incur extra operating expenses to forge relationships with clients and to get its plants up and running smoothly.

The book value as of Q1/2008 was 2.31 €/share, after which an annual dividend of 0.12 €/share was paid out. I consider the book value quite firm, and think of it as the floor for the value. Thus, I don’t really see a downside risk from the current share price.

To value Scanfil, I first calculate normalized net operating profit after taxes (NOPAT). I use the five-year average NOPAT margin of 6.0 % and ttm sales to get a normalized NOPAT of 13.3 million euros (or 0.227 € per share), and stick a P/E multiple of 10 to it (which implies a WACC of 10 %). I add the excess net cash of 0.70 € per share, and arrive at a current intrinsic value of 2.97 € per share.

The current share price of 2.22 € therefore offers a 25 % discount to intrinsic value.

Next, I take into account the recapitalization of the operating subsidiary. After the transaction, in about one year’s time, the holding company is going to have excess cash as follows:

- Current excess net cash: 0.70 €

- NOPAT for one year: 0.22 €

- Cash returned from the operating subsidiary, financed with debt: 0.78 €/share

- Total excess net cash: 1.80 €/share

In addition, the holding company still owns the operating subsidiary. The management sees flat revenue for 2008. I compute a normalized EBIT by using the average EBIT margin of 8.1 % to arrive at a normalized EBIT of 18.2 M€. Assuming an interest rate of 6 % for the debt of 46 M€, the interest expense is 2.8 M€. After taxes worth 4.0 M€ at a statutory tax rate of 26 %, I arrive at normalized earnings for the operating subsidiary: 11.4 M€. Again, sticking a P/E multiple of 10 to this, the value of the business is going to be 114 million euros, or about 1.95 €/share.

Adding the total excess net cash of the parent company, 1.80 €, I arrive at an intrinsic value of 3.75 €/share in one year’s time. The current price offers a 41 % discount to that intrinsic value.

In the valuation above, I am assuming that the company will not growth. However, the company’s ROIC is about 15 %, which is above its cost of capital. Assuming a cost of capital of 10 %, the company is earning a positive spread of 5 %. Thus, if the company is able to grow its business with similar returns on capital, the value of that growth is positive. A growth assumption of 5 % for 10 years, and then no growth, increases the value per share by about 0.50 € to 4.25 €/share (discount of 48 % to IV). A rather aggressive growth assumption of 10 % per annum for 10 years increases the value from the no-growth scenario by 1.05 €/share to 4.80 €/share (discount of 54 % to IV).

There are, however, good reasons to why some growth could materialize. Last week, China finally announced officially that it is going to grant three national 3G mobile phone network licences. The telecom analysts have been waiting for China to make their decision for several years now, and it is quite surprising how long it has been delayed. Because of the size and the growth of the Chinese market, this is likely to yield significant new business to Scanfil’s largest customers, and as a result, to Scanfil.

Another reason to expect some growth is Scanfil’s position as a low-cost manufacturer. As such, the company should be able to obtain new customers particularly in their industrial electronics segment.

The company is authorized to buy back 4 million shares (6.8 % of shares outstanding). During both 2005 and 2006, the company bough back 1 million shares at average prices of 4.11 and 2.78 €/share, respectively. Buy-backs at current levels would be accretive to shareholders, and could also act as a catalyst.

The most significant risk facing Scanfil is customer risk. Five largest customers account for about 75 % of its sales. The largest customer is Nokia Siemens Networks. So far, Scanfil has been successful in forging long-term relations with its customers. As far as I understand, Scanfil’s operations are quite deeply integrated with its customers (especially Nokia), so customers cannot suddenly change contract manufacturers. Scanfil has been very successful in scaling down its operations before without incurring any large losses or loss of profitability, as its sales declined by 25 % from 2006 to 2007. Given Scanfil’s low cost structure, it should be able to remain competitive and retain its customers, and even gain more.

Besides customer risk, a large-scale depression would obviously hurt Scanfil, too.

For US based investors, there is of course currency risk. Scanfil reports its results in euros, and structures its business so that there are no significant currency risks to euro investors. An American investor could also consider an investment in Scanfil as a hedge against a possibly declining US dollar.

Scanfil Oyj is quoted at the Helsinki Stock Exchange (OMX Helsinki, a part of Nasdaq OMX) under the ticker symbol SCF1V. Scanfil has satisfactory investor pages at http://www.scanfil.com/ with financial information going back 10 years. Scanfil’s page at Reuters’ public web site is here: http://www.reuters.com/finance/stocks/overview?symbol=SCF1V.HE. You will not find Scanfil’s ticker at many US financial web sites, such as Yahoo.

This is my first write-up to the Value Investors Club, and the one that gained me admission. Luckily, the share price did not go up much while my application was being evaluated. :-) Please, feel free to ask questions. As an investor based in Finland, I may be able to give some background and more specifics about the company.

- Completion of the recapitalization of the new operating subsidiary and possible return of capital to shareholders in one year’s time

- Value is its own catalyst: as Scanfil keeps on posting good quarterly results, the market will eventually take notice

- Any growth could alert the markets, and result in multiple expansion

- Possible tax-free sale of the operating subsidiary at a nice premium

- Possible stock buy-backs