Skellerup (SKL) Fundamentals

[Snoopy]

'MDRT' is the answer to the question:

"If all profits for the year were put towards paying off the company's debts, how long would that take?"

My rule of thumb for the answer in years is:

years < 2: Company has low debt
2< years <5: Company has medium debt
5< years <10: Company has high debt
years >10: Company debt is cause for concern

	FY2016	FY2017	FY2018	FY2019	FY2020
Bolt on Acquisitions		New Wigram factory opens		Nexus Foams (NZ) & 35% of SimLim (USA)	Silclear (UK)
Cash & Cash Equivalents: {A}	$9.510m	$6.022m	$9.681m	$9.639m	$13.617m
Non Current Borrowings:	$36.413m	$41.777m	$40.400m	$46.215m	$41.300m
add Current Borrowings:	$0.0m	$0.0m	$0.0m	$0.0m	$0.830m
equals Total Borrowings: {B}	$36.413m	$41.777m	$40.400m	$46.215m	$42.130m
Total Net Borrowings: {B} - {A}	$26.903m	$35.755m	$30.719m	$36.576m	$28.513m
Net profit declared {C}	$20.525m	$22.110m	$27.277m	$29.063m	$29.064m
MDRT ({B} - {A}) / (C}	1.3 years	1.6 years	1.1 years	1.3 years	1.0 years

In the case of MDRT it is really only the latest figure that matters. All other figures are historical, but I have included them anyway because I didn't do the calculations 'in period'. Historical figures do give a feel for how conservatively (or not) the business has been run in recent years. But having a good debt position last year is of no help if the debt has blown out this year. Fortunately debt hasn't blown out and Skellerup are in the most conservative position they have been in for five years. Yet over the period Skellerup has made serious capital investment and bought some key bolt on acquisitions along the way. Growth is being pursued while debt, although low, is being repaid. There is a lot to like in this picture. I have no qualms about giving Skellerup a 'pass' on the MDRT front.

Now having reassured ourselves that the Buffett growth model is relevant to apply in this case. let's see what happens when we apply it.

'MDRT' is the answer to the question:

"If all profits for the year were put towards paying off the company's debts, how long would that take?"

My rule of thumb for the answer in years is:

years < 2: Company has low debt
2< years <5: Company has medium debt
5< years <10: Company has high debt
years >10: Company debt is cause for concern

	FY2017	FY2018	FY2019	FY2020	FY2021
Bolt on Acquisitions	New Wigram factory opens		Nexus Foams (NZ) & 35% of SimLim (USA)	Silclear (UK)	Projects Vanilla & Tika IT upgrades
Cash & Cash Equivalents: {A}	$6.022m	$9.681m	$9.639m	$13.617m	$15.673m
Non Current Borrowings:	$41.777m	$40.400m	$46.215m	$41.300m	$24.000m
add Current Borrowings:	$0.0m	$0.0m	$0.0m	$0.830m	$0.409m
equals Total Borrowings: {B}	$41.777m	$40.400m	$46.215m	$42.130m	$24.409m
Total Net Borrowings: {B} - {A}	$35.755m	$30.719m	$36.576m	$28.513m	$8.734m
Net profit declared {C}	$22.110m	$27.277m	$29.063m	$29.064m	$40.175m
MDRT ({B} - {A}) / (C}	1.6 years	1.1 years	1.3 years	1.0 years	0.22 years

In the case of MDRT it is really only the latest figure that matters. But historical figures do give a feel for how conservatively (or not) the business has been run in recent years. Skellerup are in the most conservative position they have been in for five years. Yet over the period Skellerup has made serious capital investment and bought some useful bolt on acquisitions along the way. Growth is being pursued while debt has almost disappeared. There is a lot to like in this picture. I have no qualms about giving Skellerup a 'pass' on the MDRT front.

Now having reassured ourselves that the Buffett growth model is relevant to apply in this case. let's see what happens when we apply it.

SNOOPY

[Snoopy]

The last time Skellerup qualified for this kind of analysis was FY2014, incorporating the previous five year perspective that went with this date. There were three crucial parameters involved in the modeling which I have quoted above. For the FY2020 edition of the Buffett growth model, I have recalculated these parameters as below.

	FY2016	FY2017	FY2018	FY2019	FY2020	Average
		New Wigram factory opens		Nexus Foams (NZ) & 35% of SimLim (USA)	Silclear (UK)
Return on Shareholder Equity	14.7%	12.3%	15.2%	16.4%	15.6%	15.0% (rounded up from 14.8%)
Dividend Payout Ratio	92%	88%	71%	83%	87%	84%
PE Ratio at 30th September	11.5	16.6	15.7	15.2	19.9	15.8

The dividend payout ratio is based on the dividends actually paid out in the financial year under question - normally the final dividend for the previous year and the interim dividend for the current year, (not the dividends declared relating to the results of that year).

The number of previous years that I use to generate my data is a judgement call. Last time I used nine years of data. The more years of data that you use, the better longer term picture you get. But over time a business evolves. So the longer series of data may be less representative of the business today, and going forwards. And it is the future that is of most interest when we are making future projections. FY2016 marked the start of a 'new era' for Skellerup. I quote from the Chairman's address in the FY2016 Annual Report.

"The FY16 year included a number of notable milestones. The most significant is the completion of the of the base build of our new facility at Wigram which has enabled us to commence the careful and gradual relocation of our Agri business from Woolston to Wigram."

"Another notable milestone has been the growth we have achieved in international markets."

So this time I have elected to use my 'minimum period' of just five years, to keep my Return on Equity, Dividend Payout Ratio and market rated PE position most relevant.

Some financial analysts might see the idea of a 10 year projection forwards as absurdly unreliable, because so much can happen in that time. Buffett argues that for a special subset of businesses, that have strong internal fundamentals, it is actually easier to predict where that business will be in ten years than two. In two years any short term shock might hit. But over the much longer time period of 10 years, the underlying competitive advantage of this select group of businesses that can pass the Buffett tests are unlikely to be derailed.

For the FY2021 edition of the Buffett growth model, I have recalculated these parameters as below.

	FY2016	FY2017	FY2018	FY2019	FY2020	FY2021	Average
Return on Shareholder Equity	14.7%	12.3%	15.2%	16.4%	15.7%	20.0%	15.7%
Dividend Payout Ratio	92%	88%	71%	83%	87%	68%	82%
PE Ratio at 30th September	11.5	16.6	15.7	15.2	19.9	29.1	18.0

The dividend payout ratio is based on the dividends actually paid out in the financial year under question - normally the final dividend for the previous year and the interim dividend for the current year, (not the dividends declared relating to the results of that year).

The number of previous years that I use to generate my data is a judgement call. The more years of data that you use, the better longer term picture you get. But over time a business evolves. So the longer series of data may be less representative of the business today, and going forwards. And it is the future that is of most interest when we are making future projections. FY2016 marked the start of a 'new era' for Skellerup. I quote from the Chairman's address in the FY2016 Annual Report.

"The FY16 year included a number of notable milestones. The most significant is the completion of the of the base build of our new facility at Wigram which has enabled us to commence the careful and gradual relocation of our Agri business from Woolston to Wigram."

"Another notable milestone has been the growth we have achieved in international markets."

I have elected to use my 'minimum period' of six years, to keep my Return on Equity, Dividend Payout Ratio and market rated PE position most relevant.

SNOOPY

[Snoopy]

Nothing I have done so far has confirmed the case for investment in Skellerup. A excellent company can still be a lousy investment if the price you pay for access is too high. So is the price for Skellerup today on the market too high? To answer that I plug the modelling numbers that I have generated into the Buffett style ten year growth model.

For this model I am using:

a/ an ROE of 15.0% (the actual average of the last 5 years) AND
b/ a dividend payout ratio of 84% (the actual dividend payout of the last 5 years).

I have noted that the dividend going forwards is likely to be 50% imputed. The reason why the Skellerup dividend is only 50% imputed is that 50% of profits are now generated overseas. This tax matter has no real bearing on the operational performance of Skellerup. But from an investor perspective, this means extra tax (at a rate of 28%) must be deducted from half of all future dividends, compared to if an equivalent fully imputed dividend was to be paid. I have adjusted for this in my calculation table by including an extra tax deduction (assuming all dividends going forwards are 50% imputed, 50% non-imputed).

	SOFY
FY	Asset Backing	Operations Earnings	add OCI (*)	less Dividend	equals Retained Earnings	Unimputed Dividend Tax
2020 (historical)	0.916	0.150	0.011	0.130	0.031	(0.018)
2021	0.948	0.142		0.120	0.022	(0.017)
2022	0.970	0.146		0.123	0.023	(0.017)
2023	0.993	0.149		0.125	0.024	(0.018)
2024	1.017	0.153		0.129	0.024	(0.018)
2025	1.041	0.156		0.131	0.025	(0.018)
2026	1.066	0.160		0.134	0.026	(0.019)
2027	1.092	0.164		0.138	0.026	(0.019)
2028	1.118	0.168		0.141	0.027	(0.020)
2029	1.145	0.171		0.144	0.027	(0.020)
2030	1.172	0.176		0.148	0.028	(0.021)
2031	1.200	0.180
Ten Year Total				1.333		(0.187)

(*) OCI = 'Other Comprehensive Income' (hedging and foreign currency adjustments)

With FY2031 projected earnings of 18.0cps, and using a PE ratio of 15.6 (actual average over the last 5 years), the expected share price for Skellerup in ten years time is:

15.6 x 0.18 = $2.84

The net dividend return for shareholders over that time is $1.333 - $0.187 = $1.146 (as per above table)

Using a market share price today of $2.95, the expected compounding annual return 'i' can be calculated from the following equation.

$2.95(1+i)^10 = (2.84 +1.15) => i=3.07%

This projected 3.01% return is a net return per year. The equivalent gross return is 3.07%/0.72 = 4.26%. While this kind of return looks attractive, compared with term deposit interest rates under 2%, I don't believe it is sufficient for Warren to be interested in buying into Skellerup. What we have here is a very good company, but one that is what I would term 'fully priced'. The fact that I am predicting the share price in ten years time ($2.84) to be slightly lower than the share price today ($2.95), despite solid incremental operational growth says it all.

What Skellerup share price (P) would Warren need to buy at to get his much touted 15% compounding return per year?

P(1+0.15)^10 = (2.84+1.15) => P= 98.6c

Nothing I have done so far has confirmed the case for investment in Skellerup. A excellent company can still be a lousy investment if the price you pay for access is too high. So is the price for Skellerup today on the market too high? To answer that, I plug the modelling numbers that I have generated into the Buffett style ten year growth model.

For this model I am using:

a/ an ROE of 15.7% (the actual average of the last 6 years) AND
b/ a dividend payout ratio of 82% (the actual dividend payout ratio of the last 6 years).

I have noted that the dividend going forwards is likely to be 50% imputed. The reason why the Skellerup dividend is only 50% imputed is that 50% of profits are now generated overseas. This tax matter has no real bearing on the operational performance of Skellerup. But from an investor perspective, this means extra tax (at a rate of 28%) must be deducted from half of all future dividends, compared to if an equivalent fully imputed dividend was to be paid. I have adjusted for this in my calculation table by including an extra tax deduction column in my table (assuming all dividends going forwards are 50% imputed, 50% non-imputed).

	SOFY
FY	Asset Backing	Operations Earnings	adjust OCI (*)	less Dividend	equals Retained Earnings	Unimputed Dividend Tax
2020 (historical)	0.916	0.150	0.011	(0.130)	0.031	(0.018)
2021 (historical)	0.942	0.205	(0.01)	(0.140)	0.055	(0.020)
2022	0.997	0.157		(0.128)	0.029	(0.018)
2023	1.026	0.161		(0.132)	0.029	(0.018)
2024	1.055	0.166		(0.136)	0.030	(0.019)
2025	1.085	0.170		(0.140)	0.030	(0.020)
2026	1.115	0.175		(0.144)	0.031	(0.020)
2027	1.146	0.180		(0.148)	0.032	(0.021)
2028	1.178	0.185		(0.152)	0.033	(0.021)
2029	1.211	0.190		(0.156)	0.034	(0.022)
2030	1.245	0.195		(0.160)	0.035	(0.022)
2031	1.280	0.201		(0.165)	0.036	(0.023)
2032	1.316	0.207
Ten Year Total				(1.461)		(0.204)

(*) OCI = 'Other Comprehensive Income' (hedging and foreign currency adjustments)

With FY2032 projected earnings of 20.7cps, and using a PE ratio of 18.0 (actual average over the last 6 years), the expected share price for Skellerup in ten years time is:

18.0x 0.207 = $3.73

The net dividend return for shareholders over that time is $1.461 - $0.204 = $1.257 (as per above table)

Using a market share price today of $6.05, the expected compounding annual return 'i' can be calculated from the following equation.

$6.05(1+i)^10 = (3.73 +1.26) => i= -1.91%

This projected -1.91% return is a net negative return per year. Is this a joke? How can such a projected return every year for ten years - no less - be correct?

To understand this result, you have to realise that this is a mathematical model that will faithfully spit out a result from the data you feed it. So how good is the data the model is being fed? Notice that the projected earnings for FY2032 are 20.7cps, verses actual earnings for FY2021 of 20.5cps. IOW I am modelling earnings to be virtually flat after ten years, with years of lesser earnings in between! Is that a plausible scenario? From where we shareholders sit today, such a result would be extremely disappointing to be sure. Yet if we use the actual historic return on equity, averaged over 6 years, and the actual dividend payout ratio, then these are the kind of earnings we shareholders might expect.

This modelling is suggesting that all of those productivity improvements at Skellerup over the last few years will 'revert to a mean' i.e. go backwards. Given Skellerup have announced further productivity improvements going into FY2022, this modelling assumption looks likely to be wrong.

The second modelling assumption that is well out of whack with today's market (PE of 29) is that I am assuming a PE ratio of 18 in 2032. I did not pull that figure of 18 out of thin air. It is the actual historical average over six sample dates. Shareholders coming on board over the last couple of years (eps has grown 37% since FY2019) might like to reflect that most of their share price gains (SP +160% over the same period) have been due to 'valuation multiple expansion'. Growth in earnings has occurred. But the share price growth has way outstripped earnings growth. IMO the 'multiple expansion' that has driven so much of shareholder returns over the year or two in particular has now become a real risk factor that could sting shareholders if that PE valuation metric deflates. If that is a somewhat sombre note on which to end this analysis, then so be it. Don't e-mail Warren Buffett and ask what he thinks, as I don't think there is any chance he will be on the Skellerup share register!

What Skellerup share price (P) would Warren need to buy Skellerup at to get his much touted 15% compounding return per year over the coming decade?

P(1+0.15)^10 = (3.73+1.26) => P= $1.23c

SNOOPY

discl: shareholder, with an average entry price of $1.33

[Biscuit]

.......The fact that I am predicting the share price in ten years time ($2.84) to be slightly lower than the share price today ($2.95), ......

My bad, I paid nearly $6 to pick some up today

[Muse]

My bad, I paid nearly $6 to pick some up today

Haha, whoops. Snoop dawg thinks you’ve been had.

[Snoopy]

My bad, I paid nearly $6 to pick some up today

You were a little quick off the mark with your reply Biscuit. I have since raised my ten year price target for SKL from $2.84 to $3.73. So you are only going to lose $2.27 per share over the next ten years, not $3.16 ;-P

Seriously though, a PE of 29 is a high valuation. Yahoo finance shows two analysts following SKL

https://finance.yahoo.com/quote/SKL....lysis?p=SKL.NZ

One is forecasting eps of 23cps for FY2022. The other 24cps. Both are looking forward to FY2023 and an eps of 26c. At $6.05 this implies a forward PE for FY2022 between 25.2 to 26.3, and a forward PE for FY2022 of 23.3. Stack those numbers up against the six year historical average PE of 18.

Certainly the performance of SKL over the Covid-19 crisis period has been resilient and impressive. Do you regard SKL as now having moved on to a new level, that rather invalidates historical comparisons?

Historical gross dividend yield is:

Net dividend is: (6.5c+10.5c) = 17c (50% imputed)

=> Historical Gross Dividend = 8.5c + 8.5c/0.72 = 20.3c

=> Historical Gross Yield = 20.3c/605 = 3.4%

That yield is better than you can get at the bank for sure, but not that compelling. Does that not suggest there is quite a growth premium built into the share price already?

I have no reason to talk down SKL. It is my biggest NZX holding. But I am wondering what got you to push the buy button at 6 bucks?

SNOOPY

[haewai]

Thank you for sharing your analysis Snoopy. I recall your work a few years ago, at your entry point I think, which has been proven correct.

[Biscuit]

You were a little quick off the mark with your reply Biscuit. I have since raised my ten year price target for SKL from $2.84 to $3.73. So you are only going to lose $2.27 per share over the next ten years, not $3.16 ;-P

Seriously though, a PE of 29 is a high valuation. Yahoo finance shows two analysts following SKL

https://finance.yahoo.com/quote/SKL....lysis?p=SKL.NZ

One is forecasting eps of 23cps for FY2022. The other 24cps. Both are looking forward to FY2023 and an eps of 26c. At $6.05 this implies a forward PE for FY2022 between 25.2 to 26.3, and a forward PE for FY2022 of 23.3. Stack those numbers up against the six year historical average PE of 18.

Certainly the performance of SKL over the Covid-19 crisis period has been resilient and impressive. Do you regard SKL as now having moved on to a new level, that rather invalidates historical comparisons?

Historical gross dividend yield is:

Net dividend is: (6.5c+10.5c) = 17c (50% imputed)

=> Historical Gross Dividend = 8.5c + 8.5c/0.72 = 20.3c

=> Historical Gross Yield = 20.3c/605 = 3.4%

That yield is better than you can get at the bank for sure, but not that compelling. Does that not suggest there is quite a growth premium built into the share price already?

I have no reason to talk down SKL. It is my biggest NZX holding. But I am wondering what got you to push the buy button at 6 bucks?

SNOOPY

I think the business is transformed from what it once was but also think the price is quite ripe. I did buy some the other day at 595. Its a bit complicated, but I'm not actually adding to my long term holding at the moment. I'm bizarrely transferring holding from one entity to another and rather than do an off market transfer I thought I'd use the short term dip to buy on the one account and am currently waiting for it to go up a bit more to sell on the other account.

[Muse]

I think the business is transformed from what it once was but also think the price is quite ripe. I did buy some the other day at 595. Its a bit complicated, but I'm not actually adding to my long term holding at the moment. I'm bizarrely transferring holding from one entity to another and rather than do an off market transfer I thought I'd use the short term dip to buy on the one account and am currently waiting for it to go up a bit more to sell on the other account.

You are dead right Biscuit - this business has changed dramatically over the last 10 years and even again over the last 5 years. While the work snoopdog has put into his analysis is impressive, the execution of it is on the bizarre side and even that aside the underlying assumptions flawed. Like everyone I see SKL as fully priced and could see some fluctuations, but there are a lot of reasons why this share has been re-rated higher.

Lets take a step back. Over the last decade skl has dramatically changed its business model with its financial profile rapidly changing each year over the last 3-4 years. Skellerup has wrapped its business model around blue chip OEMs with long term macros driving their own growth. In the past SKL was more akin to a contract manufacturer prone to price & competitive pressures in less attractive more cyclical sectors. SKL has had extraordinary success in pushing up the value chain through its engineering capabilities to where it can offer whole of life technical solutions allowing it to better cross sell & upsell higher margin products & services. SKL has executed well at new product development getting it in the door and then capturing aftermarket sales with secondary products and services. SKLs customers are all undergoing lifting standards (over 50% of SKL revenues are from water or food products) growing faster than their ability to drive down prices. The segment also has higher switching costs as SKL products are critical technical components that the OEM cannot do without - particularly when SKL has gotten established providing secondary product sales and services.

Snoopy relies on past averages despite the business making dramatic incremental gains each year. Case in point: underlying EBIT in FY17 was about 15.6% of sales, which has increased every year to 20.7% in FY21A and that likely to be exceeded in this coming FY22 financial year. Its return on invested capital (pre tax) were ~16.8% in FY17A which lifted to 28.2% in FY21A and that is expected to increase to the lower to mid 30% range in the next 5 years or so. In line with that, net working capital intensity has likewise reduced as a % of sales from 30% to 25%. Higher margins, lower capital intensity has seen cashflow skyrocket, net debt reduce and dividend payout maximised.

Is the lift in ROIC sustainable or just a blip? Its most direct comparables suggest it is with SKL's measure sitting within the median even after it has improved each year. ROICs are also well correlated to their forward EBIT multiple with SKL sitting within the line of best fit. Comps include Datwler, Enpro, Hexpol, Illinois Tools, IMI, Nolato, and so on.

OEM customers have some strong long term tailwinds. Potable & waste water underinvestment is a theme globally and particularly in the united states, AU and NZ. Same with plumbing products. The agri infrastructure in the united states is in deficit so that should continue to grow alongside with global milk volumes (the OECD FAO outlook suggests volumes should increase at a 1.6% annual compound rate to 2029).

SKL has a good recent track record of undertaking immediately accretive acquisitions as well.

So personally I wouldn't be surprised to see EPS grow more that 50% from FY21A by FY24 to over 30 cps. Cheap? No. But good things rarely are. But snoopy's 10 year forecast share price of $3.73 is - for lack of better words - just silly.

[Rawz]

Thanks for your post FM. Appreciate you taking the time. Sorry cannot give you a rep, computer says no. Must share rep around first