Scott Tech looking cheap

[Snoopy]

I think at the roadshow either Hopkins or McLauchlan (can't remember which), mentioned they look for a 15% return on their new investments. But whether that has been a long established policy (I got the impression it was) or a new target hinted at by JBS, this I don't know. By way of an aside, I look for an ROE of 15%+ from my own sharemarket investments (doesn't always happen), or at least the 'growth' ones. So I am very happy that the SCT board has a similar policy.

Scott's have grown the size of their business enormously over the last five years. The JBS cash issue (aka takeover) of Scott Technology during FY2016 provided a $40.597m bucket of cash that has allowed Scott to build project engineering skill bases 'on the ground' by acquisition in Europe, Australia and the United States in particular. Yet how successful this strategy was in terms of 'earnings per share' is an open question.

If you give a kid a bag of building blocks, shaking those blocks up and throwing them on the floor will not produce anything productive in itself. But if your kid takes those blocks and tries to 'knit them together', then this process could produce something of substance. It is the synergies between blocks and any associated cross selling opportunities that will determine whether Scott's will have just 'growth in earnings' or the much more desirable 'growth in earnings per share'.

Underlying growth in 'eps' has not yet happened. So can we conclude that 'our' little kid 'Scotty' has simply taken his new blocks and thrown them on the floor? Let's find out!

SNOOPY

[kiwidollabill]

No ones talking about them writing off this small part of the business...

They shifted it out towards Mosgiel, I drive past it most days and the building always seemed to be pretty quiet.

https://www.odt.co.nz/business/dc-ro...se-8-jobs-line

[Snoopy]

No ones talking about them writing off this small part of the business...

They shifted it out towards Mosgiel, I drive past it most days and the building always seemed to be pretty quiet.

https://www.odt.co.nz/business/dc-ro...se-8-jobs-line

Thanks for this kiwidollabill. The fact that nothing was said at the AGM on the subject of 'DC Ross' and that as soon as Chris Hopkins stepped down, the new guy wielded the axe tells we shareholders a lot:

1/ Hopkins most likely did not agree with the closure plan. If he had agreed he could have put himself up as the 'fall guy' while Kippenberger as the new CEO looked towards a hopeful future with a 'rebuild the business' plan. The way it was handled makes the new helicoptered in CEO the hatchet man. This doesn't bode well for future staff management relations.

2/ The highly skilled staff at DC Ross are apparently surplus to requirements of the group. I actually thought the whole reason for acquiring DC Ross in FY2017 was to buy the skills of the staff so that, in a market with a shortage of well qualified fitters and turners, they could be quickly doing other projects within the Scott group. The fact that Scott's now seem to have a surplus of labour in this area in NZ must be cause for concern. Perhaps the pipeline of project work coming into the wider group is weaker than management are letting on?

3/ The fact that the DC Ross workers "believed the company was doing well" would suggest that they have been winning projects by putting in below cost tenders. That doesn't necessarily imply management incompetence. DC Ross may have done it deliberately to keep their staff intact, while they transition to more profitable projects. So maybe looking after the staff, Scott's best asset BTW, is not the priority it once was?

SNOOPY

P.S. He (Scott Technology’s chief operating officer, Richard Jenman) did not want to give figures on how much was being lost.

"In terms of percentage of revenue, it’s significant."

(my underline emphasis). If there is to be a 'significant' loss of revenue to the group, why was there no announcement to the stock exchange of this on November 29th? Nearly two weeks later and still no announcement to the NZX has been made!

[Snoopy]

Underlying growth in 'eps' has not yet happened. So can we conclude that 'our' little kid 'Scotty' has simply taken his new blocks and thrown them on the floor? Let's find out!

For those who came in late, Scott Technology had a very drawn out capital raising process (because of unsupportive major shareholders) that culminated in a new major shareholder, the JBS group out of Brazil, via Australia, promising to back the company into its next stage of development. The buying spree that used this new capital actually started in the year before the capital was raised, FY2015. Here is a table of the Scott Technology acquisitions over the last five years:

Year	Acquisition	Purchase Price	EBITDA Contribution	Days Owned	Annualised EBITDA Contribution Estimate
FY2015	Machinery Automation & Robotics (MAR)	$14.324m	$0.626m (1)	212	$1.078m
FY2016	Somako Hirsch & Attig GmbH	$0.880m	-$0.147m	149	-$0.360m
FY2017	DC Ross Limited	$0.375m	NM	92	$0.0m
	Scott Separation Technology	$0.433m	NM	131	$0.0m
FY2018	Alvey	$19.303m	$0.9m	159	$2.066m
	Transbotics	$4.873m	$0.8m	122	$2.393m
FY2019	Normaclass	$2.940m	NM	89	$0.0m
Total		$43.128m			$5.177m

So we can see that with these seven 'building blocks' bought, the $40.597m of capital raised has been 'well and truly spent'. Or perhaps I should have said simply 'truly spent?'

Notes

(1) The 2015 annual report does not give an EBITDA contribution from MAR. So I have apportioned the interest paid by Scotts for holding MAR after purchase to the revenue turned over by MAR relative to the revenue of the whole group.

$1.198m x ($13m / $72.298m) = $0.215m

I have estimated the depreciation and amortisation charge at MAR by

a/ Looking at the plant and equipment assets on the MAR books at takeover date
b/ Comparing that to the total plant an equipment on the Scott Technology book at the end of the year AND
c/ apportioning the total D&A to the fraction of plant and equipment owned by MAR

$1.636m x ($1.062m/$11.468m) = $0.151m

To estimate EBITDA from this:

NPAT / T + I +DA = ($0.161/0.7) + $0.245m + $0.151m = $0.626m

SNOOPY

[BlackPeter]

For those who came in late, Scott Technology had a very drawn out capital raising process (because of unsupportive major shareholders) that culminated in a new major shareholder, the JBS group out of Brazil, via Australia, promising to back the company into its next stage of development. The buying spree that used this new capital actually started in the year before the capital was raised, FY2015. Here is a table of the Scott Technology acquisitions over the last five years:

Year	Acquisition	Purchase Price	EBITDA Contribution	Days Owned	Annualised EBITDA Contribution Estimate
FY2015	Machinery Automation & Robotics (MAR)	$14.324m	$0.527m	212	$0.907m
FY2016	Sumako Hirsch & Attig GmbH	$0.880m	-$0.147m	149	-$0.360m
FY2017	DC Ross Limited	$0.375m	NM	92	$0.0m
	Scott Separation Technology	$0.433m	NM	131	$0.0m
FY2018	Alvey	$19.303m	$0.9m	159	$2.066m
	Transbotics	$4.873m	$0.8m	122	$2.393m
FY2019	$2.940m	NM	89	$0.0m
Total		$43.128m

So we can see that with these seven 'building blocks' bought, the $40.597m of capital raised has been 'well and truly spent'. Or perhaps I should have said simply 'truly spent?'

SNOOPY

Great job, snoopy - and not a pretty picture.

Obviously they might say that they need time to fit the blocks together to turn them into a money spinner. But if that's the case - why are they now reducing their Dunedin operation with the staff they would need to keep the wheels spinning?

I've seen throughout my career many companies failing this magic hurdle of attempting to outgrow its size beyond something like 500 (give or take a handful) staff. This is when the informal communication and management processes of the early "garage company run by heroes" (where communication mainly works through a handful of highly competent people who all grew their career in the same garage) need to be switched to well defined, well honed and enforced communication and management processes which work whether the stakeholders come from the same stable (and have known each other for many years) or not.

Otherwise one gets quickly this right hand does not know what the left hand does situation.

Obviously - if companies add during this phase lots of additional companies in far away countries with different culture and language, than this hurdle gets still harder to pass. Scott has now nearly 800 staff across 3 continents. Just saying.

[kiwidollabill]

The problem with DC Ross is essentially their only customers were Ford/Holden Australia, when they stopped domestic manufacturing over there then the sales for them stopped too. They had amassed a ton of debt and the major shareholder family washed their hands of the whole thing after taking their $ out years ago. They are a decent blank making firm but with such a niche its hard to diversify the business into other spaces (which is what Scott wanted to do....).

Disc I know one of the senior people there who got burned at DC

Could this be the start of write offs of sub-part businesses which Scott have bought over the years?

Kippenberger likes things lean and simple....

[Snoopy]

So we can see that with these seven 'building blocks' bought, the $40.597m of capital raised has been 'well and truly spent'. Or perhaps I should have said simply 'truly spent?'

The figure I want to focus on now is the $5.177m "Annualised EBITDA Contribution Estimate." What would happen if we add this figure to the FY2014 EBITDA figure, the year before this JBS headed capital raise was required? If we did that, we could calculate the 'building blocks thrown all over the floor' profit where there are no integration benefits or synergies from all these acquisitions.

EBITDA for FY2014: $4.231m + $0.514m + $1.336m = $6.131m

Now add in our "Annualised EBITDA Contribution Estimate" from acquisitions over the last five years:

Underlying EBITDA 'blocks all over the floor' = $6.131m+ $5.177m = $11.308m

Of course Scotts have now had up to five years to bed in all these acquisitions so the benefits of the integrations and synergies can flow through. So what was the actual EBITDA profit figure for FY2019?

According to AR2019 the EBITDA figure for FY2019 was $20.010m. However that figure was boosted by $4m because of an accounting standards change in relation to leases. So the comparable figure is actually $16.010m. It does seem then that up to $5m in synergy and integration benefits may have been realised? Then again the EBITDA increase could have just been organic growth from the core business already owned before FY2015. In truth this is a fairly 'flimsy analysis' for several reasons:

1/ I am extrapolating a part of a year earnings contribution as representative of the whole year.
2/ I am assuming that the year in which a new business unit was acquired represents a 'typical' earnings contribution for any year.
3/ There is no way to separate out 'organic growth' from acquisition synergy growth. For example, in October 2016 Scott's purchased the intellectual property associated with 'Bladestop'. 'Bladestop' is an innovative design of bandsaw with a 'double safety catch' to prevent injury to operators hands and limbs. The principal application is in the meat processing industry. Scott's have paid the 'Bladestop' intellectual property holders $6m cash with an additional $4m being set aside as an earn out payment. Because these payments are for pure intellectual property in an industry where Scotts already operates, I consider this purchase part of 'organic growth'.
4/ Given the lumpy nature of Scott's business, are the two comparative years of 2014 and 2019 truly representative? (Note: neither FY2014 nor FY2019 were great years, so I personally am happy with the two chosen years selected).

Nevertheless the figures that I have used are the only ones we are given to work with.

The other factor we need to keep in mind is that the number of shares on issue has dramatically increased over that five years. The EBITDA per share figure is as follows:

FY2014: EBITDA/share = $6.131m/44.009m = 13.9cps

FY2019: EBITDA/share = $16.010m/77.545m = 20.6cps

So perhaps the operating earnings 'growth job' put in by management over the last five years is not as bad as some here think?

SNOOPY

[BlackPeter]

.... The EBITDA per share figure is as follows:

FY2014: EBITDA/share = $6.131m/44.009m = 13.9cps

FY2019: EBITDA/share = $16.010m/77.545m = 20.6cps

So perhaps the operating earnings 'growth job' put in by management over the last five years is not as bad as some here think?

SNOOPY

Lets face it - the only thing which really matters for shareholders is the EPS trend AFTER Tax, AFTER depreciation and AFTER interest. And this number is in (8 year-) average 13 cents with a minimum of 6 cents in 2014 and a maximum of 17 cents in 2012. The 2019 result was 11 cents - even below the 8 year average.

If I extrapolate the EPS trend based on the last 8 years then the earnings CAGR is NEGATIVE 5 %. Could somebody please tell the board that this is the wrong direction?

[Snoopy]

GENERAL: SCT: SCT ATTRACTS MAJOR GOVERNMENT SUPPORT FOR R&D

10 December 2010

SCOTT TECHNOLOGY LTD ATTRACTS MAJOR GOVERNMENT SUPPORT FOR R&D

The company is pleased to advise that we have been successful in our application for the Governments Technology Development Grant. This has been awarded to Scott to a maximum of $3.7 million over 3 years and is payable at the rate of 20% of eligible spend on research and development (R&D).

-------

That's another nice little cashflow bonus for SCT shareholders. $3.7m represents 11.7cps! Note quite cash in the bank as SCT will have to spend $18.5m over three years to get the $3.7m rebate. But having such a vote of confidence in the company by the government will not do SCT any harm.

Scotts are about to enter their tenth year of being on the R&D grant system in New Zealand. These R&D grants are distributed through Callaghan Innovation. But things are changing.

If necessary, when seeking to distinguish R&D from non-R&D, the further advice provided by the New Zealand Financial Reporting Standard 13 (NZ FRS 13) should be applied:

"R&D is distinguished from non-R&D by the presence or absence of an appreciable element of innovation. If the activity departs from routine and breaks new ground it is normally R&D; if it follows an established pattern it is normally not R&D.”

The Government has announced the final design of the R&D tax incentive and Growth Grants will be replaced by the tax incentive from 1 April 2019. The Growth Grant scheme will end on 31 March 2021.

The final date for commencing a new Growth Grant application in the online portal will be 12 noon, Thursday 20 December 2018. The final date for completion of new Growth Grant applications ready for assessment and approval is 31 January 2019. All Growth Grants commenced and subsequently approved in this period will have a Contract Start Date of 1 January 2019 and a Contract End Date of up to 31 March 2021 (depending on your tax year).

In dollar terms the 'old' tax grant scheme paid out 20% of the business’s eligible R&D spend up to $25m per annum - The amount paid is up to a maximum of $5m per year (0.2 x $25m =$5m). All R&D carried out in New Zealand is eligible for consideration. However there is one particular category of R&D where no payout will be made. This is when R&D is capitalised as an intangible asset. Scott's have told we shareholders for years that they expense all their R&D and they are being conservative. That is one way of looking at things. But it does appear the real reason they are expensing all their R&D is to qualify for the Callaghan Institute R&D Grants. Nothing really wrong with that. But it would have been nice to know 'up front' exactly why Scott's are being conservative with their R&D expensing.

So what will 'the change' mean for Scotts?

SNOOPY

[Snoopy]

The Government has announced the final design of the R&D tax incentive and Growth Grants will be replaced by the tax incentive from 1 April 2019. The Growth Grant scheme will end on 31 March 2021.

So what will 'the change' mean for Scotts?

From the ird website:

https://www.classic.ird.govt.nz/rese...incentive.html

------

The key features of the R&D tax credit include:

• A 15% tax credit available from the beginning of a business' 2020 tax year
• A minimum R&D expenditure threshold of $50,000 per year
• A $120 million cap on eligible expenditure
• A definition of R&D intended to ensure accessibility across all sectors
• A limited form of refunds in the first year. This will allow some firms with a tax loss to receive a refund of the tax credit.

-------

Scott's declared R&D spending (admittedly spread between Australia and NZ) of $14m over FY2019. So there is little doubt they qualify for the $50,000 minimum threshold spend.

We can work out the dollar cap of any payment:

15% of $120m is: 0.15 x $120m = $18m.

That is quite a lift from the maximum 'payout' under the old scheme of $5m. I put 'payout' in quotation marks. That is because, under the old system, the payment was made up front with the ability to claw back payments when any approved R&D project is not completed.

A 'tax credit' has the connotation that profits must be earned and a tax bill incurred before a credit can be given. Weirdly this interpretation doesn't tie into the fifth IRD bullet point above, whereby some firms with a tax loss can receive a tax credit. I have to admit I am baffled by this. I wonder if it means there is relief from provisional tax in the ensuing year? But of course if the company is making a loss there shouldn't be any requirement to pay provisional tax!

What is clear is that this change is bad for cashflow. The R&D expenditure must be paid for up front by the company up front before any tax relief is forthcoming.

SNOOPY

[Snoopy]

What is clear is that this change is bad for cashflow. The R&D expenditure must be paid for up front by the company up front before any tax relief is forthcoming.

Scotts are also receiving R&D assistance in Australia. Information on Australian governmental assistance may be found here:

https://www.business.gov.au/Grants-a...-Tax-Incentive

The Australian R&D tax incentive replaced the Australian R&D tax concession from 1 July 2011, and applies differently from the concession.

Australia, right now, has a lower minimum spend to qualify for assistance of $A20,000 (vs $NZ50,000 in NZ). There is also a possibility of claiming for overseas R&D expenditure ('Advance and Overseas Findings'). This is specifically ruled out in New Zealand.

As an R&D tax incentive, it goes without saying that a company must be liable for paying tax in Australia to qualify. All applications must be pre-registered. Scotts qualify here, largely through their Australian subsidiary MAR.

The tax offset for a private company that can be claimed is 43.5% (for aggregated R&D turnover less than $20m) or 38.5% (for aggregated R&D turnover greater than $20m). Since the Australian company federal income tax rate is 30%, it looks like you can claim back an amount greater than your tax bill. However, Australian businesses face other taxes as well, like payroll tax (an Australian state and territory tax, levied at about 5% in Victoria and NSW). So it is possible that in practice Australian companies would not be able to claim more tax back than they were due to pay after all. Incremental notional R&D deductions above $100m of R&D spending are claimable at a lower level (the Australian company tax rate).

The Australian R&D tax incentive (no dollar cap on tax rebate with between 100% to 145% of tax paid returnable) looks to be a lot more generous than the New Zealand system ($18m dollar cap on tax rebate with 54% of tax payable refundable). I wonder if that difference is enough for Scotts to abandon their R&D program in New Zealand and move the whole lot to Australia?

SNOOPY

[kiwidollabill]

Scotts are also receiving R&D assistance in Australia. Information on Australian governmental assistance may be found here:

https://www.business.gov.au/Grants-a...-Tax-Incentive

Australia has a lower minimum spend to qualify for assistance of $A20,000 (vs $NZ50,000 in NZ). There is also a possibility of claiming for over seas R&D expenditure ('Advance and Overseas Findings'). This is specifically ruled out in New Zealand.

As an R&D tax incentive, it goes without saying that a company must be liable for paying tax in Australia to qualify. Scotts qualify here, largely through their Australian subsidiary MAR.

Not only do you need to be liable for tax there you also have to conduct the R&D spend in Australia, cant get away with a transfer pricing it to the NZ entity...

If they have a UK business you can claim R&D credits from there as long as you show the R&D involves a UK entity and they dont care where in the world the R&D money is spent.

Or this is how our accountant explained it to me...

[Snoopy]

Not only do you need to be liable for tax there you also have to conduct the R&D spend in Australia, can't get away with a transfer pricing it to the NZ entity...

Couldn't Scotts do it the other way around though? By that I mean use transfer pricing to create most of their meat processing robotics profits in Australia and then do the R&D spending in Australia at MAR?

After all:

1/ Scotts biggest shareholder is Australian based (JBS Australia),
2/ The biggest medium term growth market for meat processing robotics is in Australia AND
3/ If they can get the automated beef boning room right there are potentially very large profits in Australia, and not just from JBS.

Of course if Scotts go this way, it is probably good-bye imputation credits for NZ shareholders!

If they have a UK business you can claim R&D credits from there as long as you show the R&D involves a UK entity and they dont care where in the world the R&D money is spent.

Or this is how our accountant explained it to me...

That would be fine if Scotts venture into the UK was profitable. Profits look hard to come by in UK/ Europe at the moment!

SNOOPY

[Snoopy]

Scotts are about to enter their tenth year of being on the R&D grant system in New Zealand. These R&D grants are distributed through Callaghan Innovation.

In dollar terms the 'old' tax grant scheme paid out 20% of the business’s eligible R&D spend up to $25m per annum

Scotts are also receiving R&D assistance in Australia.

The tax offset for a private company that can be claimed is 43.5% (for aggregated R&D turnover less than $20m) or 38.5% (for aggregated R&D turnover greater than $20m).

Time to tabulate all of this government support that Scott Technology have received over the last five years:

Financial Year	Government Grants NZ (GGNZ)	GGNZ/0.2 {A}	Australian Tax Credits (ATC)	ATC/0.435 {B}	{A}+{B}	Declared R&D Spend
2015	$0.673m	$3.365m	$0m	$0m	$3.365m	?
2016	$2.172m	$10.860m	$0m	$0m	$10.860m	?
2017	$0.926m	$4.630m	$0m	$0m	$4.630m	?
2018	$1.861m	$9.305m	$0.563m	$1.294m	$10.599m	$11.0m
2019	$2.026m	$10.130m	$1.112m	$2.556m	$12.686m	$14.0m

Notes

1/ FY2015 was the year in which MAR in Australia was brought into the Scott's fold.

2/ I haven't been able to find a declared R&D spend for FY2015, FY2016 and FY2017. For the two years in which I could find a declared R&D spend total (FY2018 and Fy2019), the declared total exceeds the 'sum of the parts total' that I have calculated. I would assume this is because not all R&D expenditure is recoverable via a grant or tax relief.

3/ For AR2019, the 'Government Grants related to Research and Development' are found in section A1. The 'Research and Development tax credited claimed (Australia) are found in section A2.

SNOOPY

[Snoopy]

The Research & Development (R&D) Expense to Revenue ratio ( {A}/{B} in the table below) measures the percentage of sales that is allocated to R&D expenditures. In shorthand I will call this ratio "R&D to T."

Financial Year	Declared or Estimated R&D Spend {A}	Turnover {B}	{A}/{B}
2015	$3.365m (e)	$72.298m	4.7%
2016	$10.860m (e)	$112.044m	9.7%
2017	$4.630m (e)	$132.631m	3.5%
2018	$11.0m (d)	$181.779m	6.1%
2019	$14.0m (d)	$225.093m	6.2%

The above is what 'R&D to T' looks like for Scott Technology. But what should we expect it to look like? 'R&D to T' is very industry dependent. So the only comparison that makes sense is to look at R&D amongst Scott's peer industry players.

New Zealand ranked 21st of OECD countries in GERD (Gross expenditure on R&D) in 2018, up from 28th five years earlier.

https://www.stats.govt.nz/reports/re...w-zealand-2018

Total R&D expenditure as a proportion of GDP for the whole country was 1.37 percent, still lower than the OECD average of 2.4%. The highest spending NZ sector for R&D in dollar terms was manufacturing.

A series of NZ companies are grouped together for statistical purposes as the as the "Technology Investment Network " (TIN)

https://www.callaghaninnovation.govt...siness-numbers

The Technology Investment Network consists of 450 export-focused New Zealand businesses operating in the high-tech manufacturing, ICT and biotechnology sectors. It analyses the results for 200 of the biggest (the “TIN200”). Over 2015-2016 the businesses’ expenditure on R&D represented 8.8% of total revenues. On the TIN 'R&D to T' comparative scale then, it looks like Scott's spend on R&D is toward the lower end of the TIN scale.

SNOOPY