Shares in industrial machine specialist 600 Group (LON:SIXH) fell over 30% in early trade as a profit warning this morning warned that fourth quarter trading would be significantly below expectations. The share price was marked down fairly quickly:
Since then, the share price has recovered a little to sit just 20% down. In the bigger scheme of things, the share has basically given up all the gains it has seen in the past year and is now at a level seen earlier in January. In the longer term though, this is still ahead of the absolute lows. In the past decade the share has traded in a relatively thin range. With no dividend for most of this time (a very small dividend was commenced in 2018) this is likely to have been a very frustrating and unfruitful holding.
600 describe themselves as a world class diversified industrial engineering group who manufacture and design tools, industrial laser systems and precision components. The business is heavily North America weighted, with roughly three quarters of revenues coming from here, and the rest coming from the UK (with a token amount from Australasia). A broadly similar company, Somero (who manufacture laser guided levelling systems) recently issued their own profit warning citing the tough times (and bad weather).
Whats gone wrong at 600 Group?
The bad news comes out in a trading update this morning. Oddly enough the interim results were only issued two weeks ago, so surely things could not have changed so quickly?
As noted in our interim results, the Group has been experiencing certain macro-economic and political uncertainties across our end markets which it anticipated might create some short-term disruption to trading.
Consequently, order intake for the fourth quarter is now expected to be significantly below originally predicted levels, with orders for Germany and the Far East, in particular, suffering delays heavily influenced by the global automotive slowdown.
These are not likely to be significant. The Far East accounted for just £1.5m of revenues in the past year, and Germany perhaps even less.
We have some good news:
There has been good progress in the UK business, where orders remain over 100% up on the prior year as well as continued good performance at the newly acquired CMS business, driven by its focus on healthcare and pharmaceuticals. Gross margins across the Group are also holding up well.
However, these positive factors will not be sufficient to make up the shortfall from the likely revenue reduction and as a result, the outturn for the full year is expected to be significantly below the Board’s previous expectations.
Seemingly things must have gone wrong fairly quickly if a fourth quarter update can significantly derail the progress. The broker note from the 2nd December put profits before tax at £4.06m.
600 Group: A business undergoing change
First glance at the groups history shows that this has been a small business for some time. There have been profits, but top-line growth has been anaemic. Figures from Stockopedia:
As we can see from the projections, growth is anticipated to pick up sharply. One of the reasons for this is that the company made a large acquisition this year, an American business called Control Micro Systems. At a cost of $10m, this is a very material transaction, considering the market cap of the company now sits at around $15m.
The company also off-loaded its pension scheme this year which has allowed the excess cash to return to the balance sheet. This has helped to fund the acquisition, but not all of it: and a mixture of debt and equity has been used.
Speaking of equity, there is also a large potential overhang as there is a convertible loan note. This provides 44m shares at an exercise price of 20p with an expiry date of 2022. At present it does not seem that this level will be breached any time soon, and even more unlikely that a significant premium would be attained. At the last report there were 116m shares in issue so in the event of the warrants being triggered it would be heavily dilutive for current holders. This is before considering the share is pretty illiquid thanks to its size.
It is worth noting that the debt situation contributes to a mixed balance sheet. The current ratio is very good, with current assets much larger than liabilities. The net tangible asset position is also positive to the extent where the share price is at a discount to it. But the debt overhang presents some problems: interest charges were $659,000 in the past year, significant when set against the profits, and the convertible loan note is large to the extent that the company would not afford be able to repay it when if it matured today. By 2022 of course there is the hope that the situation will be different.
The following table from Stockopedia (from left, 2014-2019) illustrates that cash flow is not a strong point here:
Capital expenditures are high relative to profits: perhaps a consequence of the industry 600 are in and the need for innovation. So rather than the business generating cash to return to shareholders or to reinvest in itself, there has been the reverse and cash is needed to keep this on the road. A look further down reveals:
Over £10m has been raised in a mixture of equity and debt. This has ensured a relatively stable debt level across the years, which is only likely to be increased this year thanks to the acquisition.
Are 600 Group Shares good value?
There is the argument for now that much of the good news seems to be heavily discounted. The last broker note on Research Tree indicated that 2021 profits before tax may reach in excess of $5m. Stockopedia go even further and their figure for net profit is $6.37m although this may have been before the most recent downgrade. But the bottom line is that revenues will increase sharply due to the takeover, and the 600 Group of tomorrow may be a different animal to that of today.
The outstanding options provide a fairly large overhang to work with. Pricing in a likely dilution may offer a slightly more accurate representation, and for this reason the price is not as good a value as the earnings multiples imply at present.
Another issue is margins: the laser division earns higher markups than the tooling (c.20%) but this is beneath that of Somero (consistenly c.30%). It is also a capital intensive business, investing its earnings back into capital expenditures. It may be the case that organic growth is difficult. The segmental breakdown shows that there are clear opportunities to expand elsewhere, but as Somero also showed it may be difficult to break these markets if there are local alternatives.
I feel (on limited information) it is fairly balanced but the prospect of dilution is enough to keep me out. 2/5.