Laser specialist Somero Enterprises, Inc (LON:SOM) today issued a profit warning as a trading update today revealed that it would miss profit expectations for this year. This profit warning hit the share price in early trade although there have been signs of a bounceback:
In terms of the bigger picture, Somero has still been good for long-term holders, delivering a long track record of profitability. The share price had been looking to test the 400p region around 6 months ago, but the general sell-off has seen this drop along with many others in the market.
This could be considered a little bit of a shock warning. Somero are very well regarded by the market, gaining a heady 94 rating on Stockopedia. They operate in a market that could be considered to be niche, manufacturing laser-guided systems which help to create level concrete flooring and other horizontal services and evidently their services have been well in demand, posting improving metrics in consecutive years. Therefore it is interesting to see how much of a setback this is.
This comes in a trading update today. We get straight to the point:
Trading during the five month period to the end of May 2019 has fallen below management’s expectations, primarily due to adverse weather conditions in the US, the Company’s largest market. Broad sections of the US experienced the highest levels of rainfall on record.*
Helpfully, we get to know what rainfall means:
The record rainfall seen in the US has delayed project starts which in turn has slowed the pace of equipment purchased by our customers, the impact of which was seen through historically strong trading months of March and April. Whilst there was an improvement in trading to end the month of May, and although the Company expects weather conditions and therefore trading in the US will improve throughout the rest of 2019, the Board now does not expect the Company to fully recapture the shortfall caused by this extended period of poor weather in the current financial year.
And the impact on profitability:
As such, the Company now expects to deliver 2019 revenues of approximately US $87m, EBITDA of approximately US $28m, and expects to have net cash at 31 December 2019 of approximately US $18m, after one-off investments of $4.0 million related to building expansions for the Skyscreed ® 25 and the Fort Myers Training Facility as well as the $2.0 million acquisition of Line Dragon.
Comparing these metrics to forecasts, this looks like a slip off the $94m revenues delivered last year and an associated decrease in profits of around 10%. North America also account for around $65m of this turnover, so the affect must be pretty material.
On first glance this appears to be a great business to be involved in as an investor. Before today we could say the metrics painted a wonderful growth story, and one that was not too aggressively priced either:
Operating margins indicate some great pricing power: Somero are clearly a cut about the generic contractors which have to compete on price:
There seems to be other great things associated with the share. The numbers are ‘real’: there is a very high level of cash conversion and free cash flow here which is aided by the fact that the company has a net cash position, and does not need to spend a relatively large amount in capex. There is a progressive dividend in place here, which while historically has been at manageable rates has crept up a tad in recent years and may in danger. The last years accounts showed a $0.31 of dividends being paid off $0.41 of free cash flow.
In addition, the share count is shrinking, indicating the company is buying back its own shares. This is a decent thing to be doing with its funds as opposed to issuing more dividends which could be subject to taxation.
The balance sheet is also solid, with virtually all assets being tangible save for a very small goodwill balance. Considering the rate of profitability here, business would have to fall off hugely for there to be any danger. And that does not look like happening on current trends even if we know that construction is cyclical: revenues have doubled in the past six years.
Of all the businesses issuing profit warnings, Somero is one of the better ones: it is in a decent position financially and earns a good margin on its products. So one of the oddities here is that the market has never really given a premium to the price. Even during the good times, the price/earnings ratio has seen pegged back once it has gotten above the average.
One of the obvious answers is because of the sector. Somero is very much at the mercy of the construction sector, and the American one in particular. If we are to look at the UK we can see many companies that are also at modest ratings despite posting great results, reflecting the feeling that we are perhaps at peak earnings and some pain may be to follow.
The obvious response would be for Somero to move to other geographies, but sales growth there has been anaemic, perhaps suggesting alternatives or substitutions already exist. The cut in turnover for this year suggest that unless there has been a sharp decrease in the American segment, that there will only be modest growth again this year internationally. The Chinese market potentially is a game-changer for the company but there have been struggles here. Turnover actually has fallen in recent years, and the only real explanation to me is that the Chinese have simply looked at the technology and created their own versions.
Another bearish comment would be that the weather is a known factor: could this be used to cover up other reasons? It is fair to say that Somero would be very vulnerable to a downturn in construction in America and in turn large builders may use the weather as some kind of excuse to hold off on spending.
If we believe the reasons then much of the spending should come back. Somero have already set the scene for the second half of the year by predicting some of it will but not to the extent of meeting the full year expectations, but this puts into question as to whether there will be another warning coming on the next update.
Another risk factor is customer concentration. From the annual report:
Despite this, Somero is a quality company as defined by its metrics. It can be seen to be a bet on a couple of things, the bigger macroeconomic picture and the results from its investments into new products and territories. This will be a relatively expensive year for Somero, with the cash balance set to decrease by $10m amidst developments and acquisitions, but management certainly have earned some trust. Longer-term I think this is a great play, but the share price can suffer on sentiment. 4/5