Share Sleuth buys (and sells) again

On Tuesday, I added Solid State to the Share Sleuth portfolio. Having interviewed Gary Marsh, the company's chief executive in May, I, and a handful of other investors, met him and the managing directors of Steatite and Solid State Supplies, its principal businesses, last week for lunch.

The only executive missing was Mark Nutter, the finance director, who has left Solid State "by mutual agreement" after his six-month probationary period. The loss of a finance director is always slightly unnerving, but Marsh plays it down. Nutter had come from the UK arm of a large US corporation, and Solid State was not the right "cultural fit".

Putting aside an anomalous one-off profit this year*, Solid State has tripled revenue and more-than-quadrupled profit in a decade. Even so, it's not large and it's not multinational. It manufactures relatively small quantities of specialised electronic equipment for a wide roster of industrial and military customers, mostly in the UK.

Conductors on most British rail routes shoulder ticket machines manufactured by Steatite, Saab Gripen fighter planes are equipped with Steatite antennae, and UK special forces use Steatite MESH radio systems. Solid State Supplies distributes electronic components, often assembled into more valuable parts or pre-programmed for manufacturers.

Focus on profitability

The main attraction of Solid State is its focus on profitability. When contract manufacturing largely moved out of the UK to low-wage economies like China in the early 2000s, the company had, in Marsh's words, to "diversify or die".  Then just a distributor, it chose to diversify, acquiring Steatite, its manufacturing arm, which it bolstered with subsequent acquisitions. Marsh, the founder's son, was appointed group managing director in 2002, the year Solid State acquired Steatite, and has run the company ever since.

There was less money in distributing electronic components in the UK because there were fewer and fewer customers so Solid State found a way to be more profitable. It chose to manufacture products that by dint of their complexity or because of security requirements had to be made here. Its prosperity, according to Marsh, depends on two factors: The increasing use of electronics and Solid State's strategy to acquire, develop, and distribute increasingly complex products that must operate reliably in tough conditions.

To illustrate the electronification of even the most mundane products, Marsh explains how, using electronics from Solid State, Cash Bases developed a smart till that counts cash and relays the total to the store and the bank. Now money in the till can be put to work in money markets overnight, and storekeepers can operate their tills more efficiently during the working day.

Non-executive director John Lavery explains the combination of accreditations required to handle dangerous materials or sensitive data and technical requirements can sometimes reduce the number of companies able to compete for a contract down to just two. Lavery recently retired as managing director of Steatite.

Solid State's restless search for profitable niches may explain why, over the last decade, it has been successful despite the hollowing out of electronics manufacturing in the UK. Growth has stalled now though, partly due to the evaporation of £3 million in revenue from the oil and gas industry.

The diversity of Solid State's markets (defence, its biggest market, brings in about 30% of revenue) and customers (BAe is usually the largest, accounting for up to 15% of revenue) should enable it to ride out downturns and prosper over the long-term.

Suspicious of acquisitions

In order to add the shares to the portfolio I had to overcome my suspicion of acquisitions.

So far, Solid State has been a judicious and relatively leisurely acquirer, but as it grows bigger, so does its appetite. Though it's typically paid between £200,000 and £2 million per acquisition, Marsh's ambition is to spend around £5 million in future.

Overpaying doesn't seem to be in his DNA though. Marsh says Solid State walked away from Rugged Systems when the asking price was £2 million only to buy it a year later for £200,000. Blazepoint, the train ticket machine manufacturer, was bought out of administration. Creasefield, Solid State's latest acquisition, may be instructive.

Steatite's battery division was heavily dependent on revenue from big oil companies, which had dried up. Although Creasefield has a more diverse customer base, it too was struggling. Marsh says Creasefield is a third as productive as Steatite, but that will change.

Asked if Solid State would issue more equity to pay for acquisitions, he shakes his head. Not at the current share price, he says, confirming his value discipline.

There are two other things bothering me about the portfolio's newest addition. They're not negatives, but sources of tension that could have positive or negative outcomes. These outcomes should be positive for shareholders, but the tensions are, nevertheless, discomforting.

The first is the complexity of the company. Manufacturers tend to prosper if they are specialists.  Solid State specialises in customising electronics. It has sub-specialisms, batteries, rugged computers, and secure communications, for example, but as it grows it's thrusting into related fields.

Part of Solid State's attraction is the repeatable business model. The company acquires, develops, or secures the distribution of a suitably complex product, sells it to its growing customer base, and then repeats. As the business gets more complex and diverse, though, I wonder if it becomes less manageable.

'Clubby' board

I'm also turning a blind-eye to the "clubby" nature of the board. Some of the non-executive directors previously worked for long-periods in executive roles, so they're not independent. Many board members derive income on top of their remuneration by providing consultancy services. Solid State also has a lightly documented executive share option scheme (in the annual report), which is not uncommon for AIM companies.  The sums may not be excessive , but the mechanism exists to syphon money out.

Just because a mechanism exists, of course, doesn't mean it will be used to the detriment of shareholders. Retaining the services of the directors who helped shape Solid State in its current form is probably beneficial. Chief executive Gary Marsh and other members of his family are substantial shareholders, so I expect him to be a good influence.

A share price of 315p values the enterprise at about £33 million, or nine times adjusted profit. The earnings yield is 11%. Solid State's profit in the year to March 2016 was inflated though. Recalculating the earnings yield using average return on capital over the last ten years results in a figure of 9% (11 times adjusted profit).

If the company sustains profit, a 9% yield is a reasonable return on investment. If Solid State grows, as I expect it to over the long-term, hindsight will show the shares are cheap.

I added 1,070 shares at 315p, the price to buy the shares quoted by a broker. The transaction cost £3380.50 including £10 in lieu of fees.

To raise enough cash to accommodate Solid State, I removed the portfolio's holdings in Camellia and Electronic Data Processing.

EDP has been unable to grow for years and has put itself up for sale, so it's unlikely remain a long-term holding any way.

Camellia beguiled me, but I misunderstood it**.

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

*Due to a settlement with the Ministry of Justice, in which Solid State received payment for the termination of a contract before it had fulfilled it. Please see my interview with Gary Marsh for the story.

Solid State can't tell us exactly how anomalous profit was in the year to March 2016 because it might give away the size of the settlement, which is confidential. Judging by the company's prior forecasts and its reiteration of brokers forecasts, underlying profit was probably similar to the previous year.

**The trades were as follows:

Camellia: Sold 15 shares at £80.50 for a total consideration after fees of £1,201.

EDP: Sold 2397 shares at 70.1p for a total consideration after fees of £1670.30.

Share Sleuth portfolio (Thursday, 14 July)

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.