Interactive Investor

A rosy, albeit contrarian play

Turn the clock back to 14 July 2014. Tomorrow Solid State, a small electronics manufacturer and distributor, will announce a new line of business. It will be making electronic tagging devices for the Ministry of Justice, part of a system that will monitor convicted law-breakers, replacing systems operated by G4S and Serco. The share price is about 400p.

Weeks later, in early August 2014, it's the eve of another announcement. Solid State is about to tell the market the contract is worth £34 million over three years. £34 million was a shade over the company's total revenue in the full-year just completed, a record year in which the company earned more than twice as much revenue as it had three years earlier. The share price is 480p.

A year later, in July 2015, the share price breaches 900p.

Then, concern. In late October 2015 Solid State says the contract has been delayed. In half-year results published in November 2015 it elaborates. The company is on schedule, but it's responsible for little more than 10% of the full value of the contract, which is £300 million. The statement implies to me that one or more of Solid State's partners are having problems. The share price drops from over 700p to less than 400p, although it subsequently stages a partial recovery.

Then, in February 2016, calamity. The Ministry of Justice terminates the contract. In a terse statement, Solid State says it's entering "into discussions with the MoJ regarding the terms on which the relationship will end."

Today, the share price is 340p, and I'm on one end of a duff phone line talking to Gary Marsh, Solid State's chief executive of twenty years.

He's expecting a payout, and hopes to announce the terms of the settlement in a matter of weeks. The Ministry terminated the contract without cause, he says, and it has sought an amicable settlement. The tagging contract was a great opportunity, but it was overwhelmed by the complexity of the technology and integrating the work of four partners, Capita, the project leader, Airbus Defence and Space, Telefonica and Solid State's Steatite unit. Meanwhile, off-the shelf devices have improved, and although significant integration challenges remain, the Ministry has elected to jump-ship.

I think I can detect resignation in his voice. The contract is dead. The company must see what it can get out of the settlement and move on. What that means for the manufacturing facility Solid State built, and the company's plans to develop monitoring systems for the elderly and ill, remains to be seen. For now, Solid State is focusing on the settlement.

Core business remains strong

But, Marsh says, electronic tagging was a new line of business. The Ministry of Justice was a new customer. Solid State remains a profitable, expanding, business manufacturing specialist products and distributing specialist components.

The schtick, and the evidence from Solid State's accounts, is that specialisation has made Solid State highly profitable. Excluding electronic monitoring devices, a product Solid State has not delivered, and may never deliver, Steatite, Solid State's biggest company, manufactures computers, antennas, batteries and radios, mostly for harsh environments requiring high specifications. Its naval servers, for example, must withstand 30G of shock vibration, also known as a torpedo strike.

The acquisition of Steatite in 2002 was a turning point for Solid State. Before that, the company had no manufacturing division. It distributed electronic components to contract manufacturers. During the dot.com bust, contract manufacturers fled offshore, where they could manufacture more cheaply, and Solid State had to diversify or, possibly suffer a lingering death. Today Steatite earns about 60% of the company's revenue, although, through two acquisitions, Solid State has recently bolstered Solid State Supplies, which earns the remainder.

Like the manufacturing decision, Solid State Supplies shuns commodity products. It prefers to add value, pre-programming semiconductors for Renishaw, a market leading manufacturer of machine tools, for example so they can go straight into production.

Marsh says the acquisitions have catapulted Solid State Supplies into something of a sweet-spot: Big enough to poach some of the large global electronic distributors' smaller customers. While those franchises may not be significant enough to deserve much attention from their existing distributors, they'd get a lot more "mind share" from Solid State.

Customers like Renishaw are attracted by close technical relationships with Solid State, and high levels of quality and security assured by its specialist ISO accreditations. Lithium batteries, one of Steatite's specialities, are class 9 hazards, the same category as TNT. Only companies with UN authorisation can ship them. Steatite is one of a small number of UK companies authorised to handle encrypted Government data.

A dream turned nightmare

If Steatite and Solid State Supplies are humming along as they were in 2014 and 2015, then perhaps we can write off the Ministry of Justice contract as a dream that turned into a nightmare. In terms of the company's long-term prospects, perhaps nothing much has changed compared to 2014 when Solid State appeared to have a winning strategy.

Investors hoping for growth are likely to be disappointed in the short-term, though. The company expects like-for-like profit to be flat when it reports the full-year ending this month. A "soft" market and delays to two important projects have held it back.

Aerial orders for Airbus A400N transport planes were halted during investigations after one of the planes crashed in Spain*, and conductor ticketing machines were slower to come through than the company expected. The orders are flowing now, but like-for-like the company had slightly fewer orders by value in March than it did in March the previous year.

Even though Solid State's share price is lower than it was before the Ministry of Justice contract was announced, it would be erroneous to fixate on share prices. If the shares were expensive in 2014, before the dream/nightmare, they could be expensive now.

They don't appear to be expensive, though. A share price of 340p values the enterprise at just under £35 million, or about 13 times adjusted profit in 2015, and, probably, 2016. The earnings yield is about 7%.

Solid State's levels of profitability vary, but over the last nine years it's consistently earned a return on capital of more than 13%. In 2015, return on capital was 18%, very close to its long-term average, suggesting that, despite monumental upheaval, it wasn't that unusual a year after all.

Just one caveat

There's just one caveat to the rosy, albeit contrarian, conclusion: Acquisitions. So far, Solid State has been a modest acquirer. Since Steatite in 2002 it has acquired seven more companies (in 14 years). The most costly was Ginsbury Electronics in 2015. At £2.1 million, it cost less than the year's profit. Solid State's average acquisition cost is £1.2 million.

Solid State Supplies, the distributor, will grow organically for now, by adding new franchises. Steatite, though, will also grow by acquisition. As the company grows, Marsh says, it needs to make bigger acquisitions, probably one a year in the £5 million plus range. That's about twice Solid State's current profit and a bigger proportion of cash flow. It raises the question of how the company will fund the acquisition programme.

In the short term, a cash boost from the Ministry of Justice settlement might help. Long-term, shareholders, or the balance sheet, may have to bear some of the cost.

Business strategy expert Michael Porter often says the essence of strategy is choosing what not to do. Reassuringly, Marsh has given me two examples in the course of our conversation. The company walked away from £2 million of non-specialist LED business last year, and three acquisitions. As Solid State grows, and the opportunities do too, it must remain this discriminating.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

*The crash was unrelated to the aerials supplied by Steatite.

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