A platinum crucible in the rough

Joshua Baker

Capital H Management

At the current stage of the bull market, it can be hard to find a company that is reasonably priced, let alone being cheap whilst showing signs of accelerating revenue growth and at a positive inflection point for margins. Something I refer to as a three levered play to generate outsized investment gains. Maybe a fourth lever if growing dividends count too. In this instance, XRF Scientific offers top-line revenue growth that appears to be accelerating, depressed margins after a period of targeted acquisitions and self-funding investment into the business, and all at an undemanding valuation of ~5.5x EV/EBITDA, even when compared to the mining services space. Whilst overlooked by the market and with a quality management team to boot, I think XRF is a platinum crucible in the rough.

The Business

XRF Scientific is a specialist provider of equipment and flux which is used in sample preparation for x-ray fluorescence spectrometry analysis. XRF comprises of three divisions, which provide products for sample preparation, being:

  • Capital Equipment: This covers the sale and manufacturing of XRF’s Electric or Gas Fusion machines, Flux weighers and other lab equipment such as sample crushers, furnace/ovens and pressing/pellet machines. The bulk of sales are from XRF’s fusion machines which represent their core IP.
  • Consumables: This covers the chemicals consumed in the preparation of lab samples with XRF’s fusion machines. The main consumable product is Flux, which is a chemical that is fused with a mineral sample to ensure accurate spectrometry analysis.
  • Precious Metals: This covers platinum crucibles used in XRF preparation machines (new and refining), semi-finished products suitable for non-mining applications and with the investment into the Melbourne factory, customisable products. PM products are exclusively made at their Melbourne facility.

XRF’s Past & Present

XRF listed in 2006 amongst the thick of the pre-GFC resources boom with its customer base heavily skewed towards the resources sector (notably iron ore and nickel). From listing and to the peak of the boom in 2011/12, revenues grew from ~$6m to ~$25m whilst EBIT grew from ~$0.9m to ~$5.5m. Through this period, XRF made selected acquisitions which contributed to the growth. At this peak, ~95% of revenues were still mining related.

Through the decline phase, which lasted from 2012 to 2016, revenues declined modestly whilst margins compressed across all three business divisions. Acquisitions made leading into this period as well as through this period, helped to cushion the declines as well as set up the business to reduce its exposure to the resources cycle. Further dampening margins towards the latter end of the cycle and through the early recovery phase between 2016 and 2018, XRF invested heavily to expand product range and manufacturing capability. I believe that this investment into the business provides a better long-term platform and sets the stage for increased revenue growth, broadening customer reach (geographic and product diversity) and margin reversion/expansion over the next 3 to 5 years.

XRF has a longstanding director and management team who are heavily invested in the business. They have also been disciplined in capital management only raising equity twice (FY12 and 13) to support acquisitions and growth in the business, whilst since then all other investment initiatives and acquisitions have been self-funded. Pay for directors and senior management aren’t egregious by resource sector standards, whilst little is given away in stock options/rights. Shareholdings of insiders has come via stock in acquisitions or through on market purchases. I note directors and senior staff have been buyers through the investment phase at similar or higher prices than current (as the date of this thesis). As such, I believe management are wholly aligned with shareholders and are essentially rewarded through dividends and sustainable long-term share price growth, not freebies at the expense of shareholders.

The XRF Opportunity

The Resource Cycle

The first driver of revenue growth comes from the resources cycle, with the sector contributing around 60% of overall revenues. Within this, the best I can ascertain is that around 30% of this is still driven by exploration cycle. As such, 40% of overall revenues is driven by production product quality testing (a relatively steady and growing base). The remaining ~20% of overall revenues driven by broader exploration spend, thus making it a material swing factor despite XRF diversifying is business over the last 7 years. Latest ABS stats show that domestically, with commodity prices trending up, exploration spend is following.

However, not all exploration spend is created equal as some methods are more expensive (i.e. diamond drilling). What is an equally important measure to look at is total metres drilled as well, which is also trending and growing in-line with commodity prices and exploration spending. I note that the rate of growth may have peaked but remains a tailwind for XRF. This increase and growth in activity is also evidenced by commentary in the reported results of XRF customers such as ALS who are seeing strong volume growth in their commodities business. In addition, they provide positive outlooks on higher sustained growth rates in this segment.

Globally, similar trends are being reported (as evidenced by PWC’s Mining Report Series, S&P Market Intelligence Reports) with exploration spend accelerating over the last few years, growing at around 15% and potentially accelerating, albeit coming of a cyclical trough as it is domestically. This provides a supportive backdrop for some of XRF’s global customer such as ALS, SGS and Bureau Veritas. The graph below is courtesy of ALS.

Product Development

XRF has worked on a product refresh around 3 to 5 years ago in addition to new product initiatives. Some notable highlights include automatic electric fusion machines in 2013, the xrWeigh Carousel in FY16 and the Phoenix 2 in FY16/17. They recently updated in 2019 they are building a new machine that expands opportunities in non-resource sectors. In late 2016, XRF added precision platinum products that contribute to their expansion into non-mining sectors, which are the focus on their EU business. For new or revamped products, it can take a few years of products being in market and used by early adopters to build use cases (i.e. justify upgrades) or workflow adaptations from new features to drive sales in more conservative customers longer-term. This creates a platform to boost capital equipment sales over the medium term.

What this creates is the potential to grow market share with new, improved and leading products, whilst it also encourages a replacement cycle amongst existing customers. With a broad recovery in activity, revenue and profits amongst key customers, I believe this can manifest in increased CAPEX that could benefit XRF as their customers look to add additional equipment at the margin to increase serviceability or upgrade equipment that has be run a little harder and longer.

Other product initiatives within the PM division includes precision platinum ware and customisation. The precision products include semi-finished PGM products (foils, sheets, wires) suitable for non-mining applications, done alongside the EU expansion. With the heavy investment in the Melbourne factory, XRF can offer customised PGM products. These initiatives broaden the potential customer base and allow XRF to offer better overall service levels to their customers, which provides a competitive advantage.

I also believe that a refreshed and expanded product set with proven usage supports XRF’s growth initiatives in new markets and segments, with the most value add from cross-sales into the expanded European business, which has predominately focused on selling PM division products.

Investment in the Business (Acquisitions and CAPEX)

As noted earlier, XRF has made periodic acquisitions, with a focus on using them to expand their geographic footprint. The acquisitions of Socachim and Scancia provided XRF with established customer and distribution channels to work through and leverage off. I note that Socachim was a main EU distributor of XRF products already and I believe that by making this acquisition, alongside the other EU centric ones, this would allow XRF to own these channels and networks so that they can diversify the business (geo region and end user segments) and accelerate sales growth across the product suite.

The other side to this part of the story is investment in the business. Through 2015 to 2018, XRF invested across the business, with the most notable efforts being expansion of the EU business into Germany and a complete rebuild of their manufacturing capability in Melbourne (higher capacity, process automation and ability to make customised products). I estimate that XRF funded (via cash flow and debt) close to $5m in upfront CAPEX, working capital and initial operating losses, which I consider impressive for a sub $30m business to do considering it was done during a low point in the cycle for revenue growth, margins and cash flow, whilst still paying a dividend. Expectations are for ROIC to be 20%+ from this investment after 5 years.

Early in the Margin Reversion Story

With the bulk of the acquisition and investment spending behind, XRF can focus on taking advantage of the operating leverage in the business model as sales accelerate. Phase 1 of margin expansion that XRF is showing currently is rolling off the expensed investment costs and losses associated with supporting the EU expansion (I note the German office is flirting with breakeven). Phase 2 comes from leveraging the sales and manufacturing platform in which incremental sales will flow through to the bottom line driving higher margins. Phase 1 is likely to play out over the course of FY19, in which I expect overall margins to around the mid-teens. Phase 2 will pay out over the next 5 years, in which I expect margins to revert closer to prior peak levels in the low to mid 20% range. As a mental exercise, if revenues were to grow at 10% p.a. for the next 5 years, operating earnings would grow at around 20% p.a., as illustrated below.

With the margin recovery comes strong growth in earnings and return on equity. Historically, the share price and valuation of XRF has been correlated to ROE, thus as margins and profits revert to longer-term highs, I believe this will support a re-rating in the share price.

Risks

No story is risk free and these are the key risks to note that could derail the opportunity:

  • Global recession or geopolitical risk. A global recession or activity risk from events like reversion to increasing trade war escalation would materially impact the resources sector as a driver. As falling demand will result in lower prices, which puts production volumes and exploration spend at risk. For XRF, this would directly impact consumables as lower volumes and metres drilled means less flux demand, whilst at the second derivative level it would put off capital sales.
  • Execution risk. Whilst the German office is on the cusp of being consistently profitable and the back-end of the business has been optimised to support a bigger operation feeding a more diverse customer base, there remains long-term execution risk to justify product expansion and investment spend. Whilst initial signs appear promising, it can take a longer-term and focused effort to sustain and grow sales in new verticals organically and take market share in existing markets to extract value out of the investment made to support these initiatives. Slower than expected growth or outright failure would prove to be return dilutive and temper revenue and margin growth expectations.
  • Input cost risk. Beyond labour, lithium prices and the AUD are key sensitivities into the business. Lithium prices have recently moderated as an oversupply has emerged and is expected to persist in the mid-term. However, there is a risk that lithium prices could find a base and move higher sooner than currently expected which would become a headwind to consumable margins. The AUD is also an issue as materials and components are imported to produce products thus a weakening AUD would put pressure on margins. Given XRF aims to transact in AUD as much as possible, a lower AUD could improve the relative price competitiveness of XRF in which case there the potential for volumes to offset margin compression (a game of relative deltas) and potentially mitigate the overall headwind to profit growth. Vice Versa for a rising AUD. I note that for the PGM business, given the pricing mechanism used by XRF, platinum price risk is borne by the consumer thus negating input price risk for this division.
  • Threats from new technology. There is always a threat that a new technology could come along replacing XRF spectrometry or a competitor with a better fusion device, however, validation takes time as does convincing lab analysts to take it up en-masse. Particularly if a methodology such as XRF spectrometry is considered a gold standard. As such, any new tech would take a long time to slowly eat away. Even with the growth in the use of hand-held XRF devices, this has not displaced the need for lab XRF analysis as is typically complementary in directing and optimising exploration on the ground.

Valuation

Based on my forecasts, XRF trades on a FY19 EV/EBITDA multiple of ~5.5x or a P/E of ~10.5x, which is towards the low end of the range for peers and comparable business, even after starting to re-rate this CYTD. However, given the specialised nature of the products and services provided coupled with above average revenue/profit growth, above average margins and the move to a more diversified non-mining customer base, I believe XRF should trade at an EV/EBITDA multiple towards the top end of the peer group which is around ~8x to 10x (makes for a P/E of 15x+). If this is not a favoured valuation metric, using PE, EV/FCF & Dividend yield metrics also suggest that XRF is undervalued by a similarly materially amount.

All in all, with the potential for accelerating revenues growth and reversion in margins, I believe the current valuation offers investors with a margin of safety, thus a positive asymmetry in return outcomes.

A microcap in this space that offers a reasonable analogy is Laserbond (LBL). LBL spent years investing in its business, sales, products etc... as well as getting through the long time it takes to validate products/services and their broader target market within the resources/industrial sectors to use them.

LBL recently hit an inflection late last year as the befit from this investment is really coming through to sales, which are rising across the board from both new/existing customers locally and in the US, as well as tech licencing with a UK engineering firm. The EV/EBITDA multiple prior to this inflection was a little under 4x which was too cheap for similar companies within the sector. A re-rating has since occurred was as investors could see higher and accelerating long-term revenue growth potential emerging with a business that is positioned to scale (i.e. margin expansion). A key difference is that XRF has a better history of how the business looks under various trading conditions and investment initiatives, whereas LBL was more about finally benefiting from years of investing and work. Either way, what it does show is that the market will re-rate these types of companies as they start to show the goods.

Disclaimer: Any information contained in this article is limited to general financial/investment advice only. The information has not taken into account your specific needs, goals or objectives, so please consider consulting a licenced and trusted adviser before acting on the information. XRF Scientific is a very small and illiquid company, and like all companies, it has an uncertain future. Therefore, an investment in XRFs shares should be considered high risk. The author owns shares in XRF and no other listed companies mentioned in the article at the time of publishing.


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Joshua Baker
Portfolio Manager
Capital H Management

Joshua has worked as an Investment Analyst across different verticals of the financial sector for 9+ years. Experience includes equities research (long/short), manager research and multi-asset portfolios.

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