Somero Enterises Inc.

Somero Enterises Inc.

AN OPPORTUNITY PRESENTING SIGNIFICANT GROWTH PROSPECTS

Headline

Somero is a quality company trading at a reasonably attractive price. Although a lot of the growth seems to be priced in, it still looks an attractive buy. It also offers and attractive indirect exposure to the industrial space (boom in online shopping that is to come across the world, the immense potential this has in places like of China and India, and, the resulting growth in high-spec warehousing needs all this is going to cause). Somero, with its unique and patent protected product line; near 100% share of the market; and, high barriers to entry, is well placed to tap into this prospect.

Investment thesis

• Somero designs, assembles, and sells patented, laser-guided equipment that automates the process of spreading and levelling volumes of concrete for commercial flooring and other horizontal surfaces such as paved parking lots. The company enjoys a near 100% share of its market and enjoys very high barriers to entry. Basically, their technology can get a floor to be as flat as it can get, which apparently adds a lot of value in today’s warehouses and other commercial buildings.
• If you are like me, you would immediately ask – why the need for such precision in floor flatness?; what’s this all about? Having done a a bit of digging around, it appears that this is quite an in-thing for modern warehouses. Now a days, flat floors are a must for ultra-sophisticated warehouses using unmanned forklifts, where the goods and parts may be stacked on shelves 20 feet or higher. Flatter and more level the floors, lower is the maintenance cost, and it also provides for improved operational surface for many types of businesses. As a result, the demand for flatter floors is being seen in many different types of projects, from warehouses to retail store operations. Just think of Amazon’s giant ambitions, think also how all the other retailers are selling more stuff online, and think of the immense untapped online shoppers in China and India, all this means many more large/high-spec warehouses need to be built, and unmanned forklifts will need flat floors. 
• Somero’s innovative products employ laser guided proprietary technology to achieve a high level of precision in concrete surface flatness at a higher rate of efficiency than conventional methods. This results in the highest level of flat-floor precision attainable at less cost to the flooring contractor.
• Having done my research, and done the numbers, I think that Somero is a good buy. Although I feel that a lot of growth is priced in, I still think it is value for money at current price. To me, the key drivers of value and growth are as follows:

• Growth in global online sales will drive the need for sophisticated warehousing – companies are going to need warehouses that can stock goods at 20feet and above and operate with unmanned forklifts; these warehouses will need flatter floors. Somero is best placed to take advantage of the demand for better floors (a range of companies, such as Costco, Home Depot, B&Q, Daimler, various Coca-Cola bottling companies, the United States Postal Service, Lowe’s, Toys R Us and ProLogis have specified the use of Somero’s Lazer Screed technology for their buildings)
• Somero’s product is unique (I think the only one of its kind) in doing what it does; patent protection; and continuous innovation create strong barriers of entry
• Somero also seems to enjoy a fantastic Sales to Capital ratio – at 2.48 – this is really good. Not only are they significantly cash flow generating, the very good sales to capital ratio also helps keep the reinvestment rate and ROIC at a very healthy level (current ROIC is >42%)
• The company has a strong focus on Customer Support and training; when combined with its unique technology, this adds significantly to the barriers of entry and creates strong operational leverage
• Increased availability of Third-party Financing(e.g. more recently in China and India)
• Growth in China and India and other emerging markets. Although emerging markets are not the flavour of the month, there are a lot of people who live there. And, some of the statistics are staggering – for example, China consumes 30x cement to the US; India consumes 3x cement to the US; both markets are a very small percentage of Somero’s current sales, and have shown significant growth in the last year. This has the huge potential. And some the strides that the Company has made in China is very positive in this regard.  
• Finally, on valuation – as they say, it is only a good investment if the price is right. It can be a great company; it can be a great product; it can have a flamboyant and likeable promoter, but if the price is not right, you aren’t going to make a return. Somero currently trades at £144.50p. I value the company at £146p on a conservative basis; my value for the base case is £174p; and my value for the positive case is £209p. All of my scenarios assume a growth rate which is below what the company has experienced over the last 4 years (in fact, for FY2015, the trading update from the Company predicts that it will beat the FY14 growth). Therefore, there is a case to be made for an even higher value. Please see my DCF analysis below.

Detailed analysis

About Somero Enterprises

• Somero designs, assembles, and sells patented, laser-guided equipment that automates the process of spreading and levelling volumes of concrete for commercial flooring and other horizontal surfaces such as paved parking lots.
• Somero’s innovative, proprietary products employ laser guided proprietary technology to achieve a high level of precision in concrete surface flatness at a higher rate of efficiency than conventional methods. This results in the highest level of flat-floor precision attainable at less cost to the flooring contractor.
• The Company sells its products primarily to concrete contractors for use in non-residential construction projects. Its Laser Screed equipment has been specified for use in constructing warehouses, assembly plants, retail centers and in other commercial construction projects requiring flat concrete floors.
• Somero’s assembly operations are located in Michigan, USA with headquarters in Florida, USA. It has sales and service offices in Chesterfield, England; Shanghai, China; and NewDelhi, India.
• Somero is listed on the Alternative Investment Market (AIM) of the London Stock Exchange (LSE) and its trading symbol is SOM.L.

A Unique product with high barriers to entry

• Somero is the only player in its niche market segment. There are significant barriers to entry due to the technology, patents, NPD and service provision adopted by Somero. The company has near 100% market share.
• Somero’s Laser Screed equipment has been specified for use wherever a flat concrete floor is required, including constructing industrial warehouses, assembly plants, offices, factories, schools, hospitals, sports complexes, big box retail outlets and retail centres.
• In addition to its unique product and superior technology, the company promotes customer training, technical support and continuous product innovation towards its global customer base, to which it regularly passes on its knowledge and expertise.
• Founded in 1985, the company has grown by delivering industry leading products to an international market (sells in over 90 countries). Its products drive efficiency for the end user (reduced construction time, flatter and with fewer people). Therefore, the company's vision is for its technology and processes to be used wherever a redi-mix truck is discharging concrete for a concrete slab.

 Significant growth prospects in China and India

• North America (largest geographic market by sales at present) and China (a big growth market for the group) equate to 78% of sales at present and these are both performing very well (YOY revenue growth of 46% and 45% respectively).
• The company had $9.5M of sales in China in FY2014, compared to $37.2M in North Market. The opportunity is massive as China's cement consumption is 30x larger than the US cement consumption.
• In China, with the company's relationship with CBMF (China Building Materials Federation), it is helping to develop the standard and accreditation for concrete floors. It continues to invest in sales, specification engineering and marketing, including exhibiting at trade shows. Rising penetration rate in China, which is currently estimated at 1%, will provide ample opportunity to increase growth going forward. The company announced in its FY14 results that its Chinese customers now have access to financing options made available specifically for Somero® equipment, which is expected to have a positive impact on sales in the region. The company has also added a new facility in China, opened a Concrete College, and with the financing option, is poised to experience significant growth in that market.
• The India market has also experienced significant growth. With two salespeople and a support technician, sales increased from US$ 0.0m to US$ 0.6m. Cement consumption is 3x larger than in US, offering significant growth prospects for years to come.
• As can be seen from the regional sales break down, the company currently generates most of its revenues from its North American markets. However, it has experienced impressive growth, from a very small base, in China and India in the last two years; in addition, it has taken strong initiatives to tap into this opportunity. When one compares the size of the markets in China and India (30x and 3x the size of US respectively), and the immense potential, this is a significant opportunity.

Regional sales breakdown	31/12/2014	31/12/2013
	USD '000	USD '000
North America	37.2	25.5
ROW (China)	9.5	6.6
EMEA (Russia)	0.7	2.3
EMEA (Middle East)	0.8	2.1
ROW (Australia)	3.1	2.3
EMEA (Europe)	3.6	3
EMEA (Scandinavia)	0.6	0.4
ROW (Korea)	0.6	0.2
EMEA (India)	0.6	0
ROW (Latin America)	2.6	2.7
Total	59.3	45.1

Strong Management team with a good track record, and vision

• This highly knowledgeable and experienced management team has executed its strategic initiatives very well. It has in place a strategic plan to of using key drivers to US and European growth as a roadmap for emerging market expansion. With demand continuing to recover in developed markets such as North America, and very strong potential for growth in emerging markets such as China, India and South East Asia, I see a growth opportunity in these markets way beyond next 5 years. Management is well on target to achieve its target of doubling revenues between the period 2013A and 2018E.
• Management’s vision for Somero is that it isn't in the business of simply creating machines and products to sell into the concrete placement market. At the centre of the business is an incredibly strong and unmatched customer service offer and ethos (see further below). It is clear from the customer testimonials, product performance, and quality, that the company is well liked and has strong operational leverage. I believe that Management's approach is creating strong barriers to entry. 

New Product Development

• Somero looks to be committed to constantly improving its current products while researching and developing new technology for better, more innovative products of the future. This has come through in its financial results.
• New products made a strong contribution to the company's financial results in FY 2014. Three new models, the new S-22E, S-11M and the S-15R were the most significant contributors to the company's overall results. The company targets at least one new product a year and spends 2-3% of sales towards product development.
• As an example of the company’s continuous success with new produces, in 2014, Somero introduced the S-485 Laser Screed®. Designed for easier set-up and operation, Simplicity Defined is the motto for this new LaserScreed®. It requires one less person to operate andonly one person is needed to establish grade or fine tune the programmable height receivers. The company has had an outstanding response to this new machine as it was just introduced in October and contributed US$ 0.9m to 2014 sales. Product development continues to be a focus of growth plans and the company is always working towards new and innovative ideas to introduce to the industry.  

A good/solid offering to its customers

• The company offers excellent customer service which would be difficult to replicate, particularly for any business that might attempt to use price: lower margins to grab a foothold in the market.
• All customers have good things to say about the quality of its product – the feedback seems to be, it does what it says on the tin very well.
• Somero seems to be very good at working with customers to help maintain the equipment’s built-in value with a variety of services which again both defends market share and offers growth opportunities. Additional services to customers include:

• Customer training: In 2013, Somero increased customer training via the customer service team by 100%. Coupled with customer feedback, it led to the development of the SCC (Somero Concrete College) with a view to increasing customer knowledge about higher quality flooring installation as well as increase customer loyalty. This is initially being offered into the Chinese market and will be rolled out to India over time.
• Equipment Evaluation / Mechanical Repairs: A trained technician provides a detailed evaluation of parts and services required to make clients machines run like new, delivering maximum value and increased customer loyalty.
• Service Contracts / Extended Warranties: The company offers extended warranty and service contracts to its customers.
• Instant Troubleshooting and Service Partners: The company offers 24/7 service coverage for its machines.

 

Historic financial performance and balance sheet strength

• Somero has experienced a 28% CAGR in revenues over the last four years – FY11 to FY14. It has clearly enjoyed the recovery in its main markets in North America. Although it might give an impression of being a cyclical stock, I believe that it is way more than just a cyclical play. If FY14 is any indicator, the expansion opportunities that the company has in China and India could be immense.
• The uniqueness and technological superiority of its product has enabled the company to enjoy very strong margins – Gross Profit margin of 54% and Operating Margin of 21% in FY14. I believe that the Company will be able to maintain its margins due to its product superiority, near 100% market share, and strong barriers to entry.
• The Company’s ROIC has been very impressive at >42% in FY14. In addition, as the company assembles component parts, it requires very low levels of ongoing capital expenditure. Its sales to capital ratio stands at a very impressive 2.48. I see no reason for the company to not be able to maintain this trend for the foreseeable future.
• After capitalizing operating leases, company’s debt:equity ratio is an impressive 2.2%. In addition, the company generates significant positive cash flows from its operations. All indicators of a good margin of safety.

 

Valuation

 

Conservative case

Assumptions:

1. Revenues experience 15% CAGR over the next 5 years, then taper off over the following 5 years, to 2.75% in year 10. The company has experienced a compounded annual revenue growth of c28% in the last four years; this when it hardly had any penetration in the significantly larger markets of China (30x US market) and India (3x US market)
2. Operating margins stay at the current level of 21.77% over the next 5 years, then taper off over the following 5 years, to 11% in year 10
3. The company has to reinvest adequately to maintain its 2.48 sales to capital ratio. Note that the company forecast’s 2-3% of revenues being invested on new product development; my DCF reinvestment rate is 1.75 to 2.63 times the level forecast by the company
4. I have assumed a cost of capital of 11.02% over the first 5 years, tapering off to 8% in year 10

 

Base case

Assumptions:

1. Revenues experience 20% CAGR over the next 5 years, then taper off over the following 5 years, to 2.75% in year 10
2. All of the other assumptions are consistent with the Conservative case
    
    

 

 Positive case

Assumptions:

1. Revenues experience 25% CAGR over the next 5 years, then taper off over the following 5 years, to 2.75% in year 10
2. All of the other assumptions are consistent with the Conservative case