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Raman Minhas
Raman Minhas
Articles (7)  | Author's Website |

Could This UK Micro-Cap Be a Peter Lynch-Type Stock?

AB Dynamics could fit the profile and has an attractive valuation

September 15, 2015 | About:

Over his 13-year tenure, Peter Lynch, the famed manager of the Fidelity Magellan fund, averaged a 29% compound annual return. One of the approaches he describes in his investment classic, “One Up On Wall Street,” was to divide stocks he was researching into one of six categories: Slow Growers, Stalwarts, Fast Growers, Cyclicals, Asset Plays and Turnarounds.

Using this classification is a helpful way to frame your thinking since stocks from different categories can have different characteristics, while still being potentially valid investment opportunities.

It’s the opposite of the “man-with-a-hammer” approach, where every situation has a single, hammer wielding solution. Having multiple ways of looking at and thinking about situations can help you see the wood for the trees.

Lynch used five out of the six categories for investing via Magellan (he generally avoided slow growers). A wide approach was necessary since the fund grew so large. But he favored the fast growers with 20-25% earnings growth. This is the hunting ground for his famed “ten-baggers” and are stocks which have the potential to really move the needle on a portfolio - particularly for private investors where two or three of these can make an investing career.

Other features he favored include having a focused business strategy, avoiding “di-worseification” and a displaying proven track-record with growing revenues and earnings over time. Since he didn't like to overpay for growth, through his investing style and writings he became a champion of "Growth at Reasonable Price" (or GARP) investing.

One of the famous acquisition criteria Warren Buffett repeatedly writes about in his letter to shareholders was “demonstrated consistent earnings power (future projections are of little interest to us, nor are “turnaround” situations”)" Source: 1989 Letter to Shareholders.

Signs that these are reproducible include a competitive moat (difficult to judge well) and strong return on equity indicating management is using shareholders funds well. Buffett is also a big proponent of the power of focus, for individuals and companies.

Adopting the above philosophies in my own investing, the following company is a UK micro-cap that could fulfill the criteria. I’ve written in the form of a stock-note so the reader can more easily follow (and critique) my thinking:

AB Dynamics PLC (LSE: ABDP) - Stock Note

BUY Price: £2.10 Current price: £2.01

Market Cap = £34.9 million Enterprise Value = £30.0 million PE(ttm) = 16.7

Sector: Scientific & Technical Instruments

Summary

  • Specialist and niche focus providing testing for automotive sector, with over 30-year trading history, selling to top 20 manufacturers
  • Five-year revenue growth of over 50% CAGR, with 14% growth last full year; recent earnings growth of 20% CAGR
  • Growth driven by Advanced Driver Assist Systems and demand from China; nearly 90% sales internationally
  • High ROE > 20%, strong balance sheet with no debt, net margin > 15%
  • Significant shareholding by founder and management
  • Attractive valuation, with PE ratio in lowest quintile for peer group
  • Acquisition potential as a specialist and well-established provider

Business Description

AB Dynamics is involved in the design, manufacture and supply to the automotive industry of advanced testing and measurement products for vehicle suspension, brakes and steering. This is for both use in the laboratory and on the test track.

The company designs and manufactures specialized systems for Kinematics and compliance testing, vehicle dynamics testing on the track, driver assistance system testing, autonomous vehicle testing, steering system testing and noise/vibration testing of powertrain assemblies.

Its products are used for research, development and production quality control. The company is UK-based with nearly 90% of sales to export. It sells to the top 20 automotive manufacturers including car manufacturers (e.g. BMW, Honda, Toyota, Ford and Volkswagen); and tier 1 suppliers (e.g. Continental, Goodyear and Michelin, Thatcham and MIRA).

The company was founded in 1982 originally as an automotive consultancy. It moved to provide specialist products for automotive testing from 1995 and listed on AIM LSE in 2013. The founder, related parties and management combined have a material interest with over 45% of the shareholding (there is no ultimate controlling party).

Financials & Ratios

Year

2010

2011

2012

2013

2014

TTM (½ yr)

Revenue (£M)

2.66

6.50

8.91

12.17

13.85

14.71

Gross Profit

0.36

1.34

2.47

3.12

4.03

4.52

Gross Margin %

13.67

20.67

27.67

25.66

29.10

30.69

Operating Income

-0.18

0.73

1.80

1.89

2.65

3.03

Operating Margin %

-6.63

11.23

20.19

15.55

19.14

20.59

Net Income

-0.05

0.50

1.43

1.42

2.15

2.55

Net Margin %

-1.77

7.71

16.07

11.69

15.54

17.30

Shares Outstanding (M)

-

-

13.4

15.0

17.8

17.8

PE ratio

-

-

-

13.95

13.80

17.78

Debt: Equity

0

0

0

0

0

0

ROE %

-

15.65

35.21

22.05

23.20

24.74

Data from GuruFocus and company reports

Stock Price Chart

Revenue and Earnings Growth

Full-year 2014 revenue was £13.85 million, with £14.71 million trailing 12-months (ttm). Revenue growth over the last four years has compounded at 50% annually but off a low base. Last year showed nearly 14% revenue growth from 2013. Product sales make up 69% of revenues while construction contracts (services) are 31%.

Track testing makes up 68% of total revenues, which includes testing for Advanced Driver Assistance Systems. Growth in revenues is driven by increasing demand for ADAS and growth in China. ADAS includes safety features to prevent accidents by alerting the driver to potential problems or avoiding collisions by taking over control of the vehicle. ADAS is the fastest growing part of the automotive market.

Independent industry reports estimates the global market size for ADAS to range from $50 billion to $90 billion by 2020, with CAGR of over 20% to 30%. Currently, 8% of vehicles are fitted with ADAS in Europe and the U.S., and 2% in developing countries. This is expected to grow to over 50% by 2020. Much of the predicted growth is driven by existing and growing focus on safety and increasing requirement by independent safety testing bodies such as EuroNCAP.

While specialist providers of ADAS testing will be a much smaller percentage of the above market size, its growth should move somewhat in line with the broader ADAS market.

Over the last four years, margins for ABDP have ranged from 26% to 31% (gross), 15.5% to 21% (operating) and 13.7% to 17.2% (net). Net margin of 13.7% in 2013 excludes an exceptional cost of £0.32 million for the AIM placing cost in 2013; including this the net margin was 11.7%. This has led to annualized earnings growth of over 20% for the last two and a half years (the numbers are much higher from earlier years due to a low base).

The current PE of nearly 17x is low for its peer group. which ranges from 10x to over 40x for companies of similar size to a £7 billion market cap. ABDP is in the lowest quintile for PE valuation among its peer group.

Return on equity is good and over 20% for the last three years, and ABDP has a strong balance sheet with £7 million in cash and equivalents with no debt.

Buy Price

When calculating buy price, I use conservative numbers (reducing downside risk) to project out revenue and earnings figures for three years and look for a 15% CAGR in stock price. Why three years and 15%? Three years as it’s still close to the historical trend while allowing value to out. We use 15% as it’s a moderate hurdle, but doesn’t require as optimistic scenarios as more aggressive hurdles.

For three-year forward growth projections, I have used 12% CAGR revenue growth and a 15% net margin. There are 17.8 million fully diluted shares; this gives a new share issue rate of 3% per year since listing in May 2013. I have also allowed a PE ratio of 20x as this is still a low valuation for its peer group, and ABDP has good growth prospects with acquisition potential (e.g. HORIBA’s July 2015 acquisition of MIRA Ltd.) to expand automotive developement and testing, including for next generation autonomous vehicles).

Using these figures gives a three-year forward fair price of £3.19. To achieve a 15% CAGR on the stock price, this means the buy price today would be £2.10 or below.

Risks

Looking at the historical data is useful to provide track-record of performance. But when assessing if such trends can continue into the near term, we have to think about what could go wrong to prevent such growth. Of course, we can never reliably predict what will happen, but awareness of risks is a useful sanity check.

In addition to risks inherent with any technology based company operating internationally, the following risks from ABDP’s annual report are particularly worth pointing out:

Intellectual Property

ABDP does not have a formal policy of filing patents on its testing or measurement systems. While barriers to entry are high -- it has a niche focus, know-how, strong industry experience and relationships, and is investing in new product development -- competitors could copy and sell similar products. Competitors could also file patents in related areas which could restrict ABDP’s freedom to operate.

This may also be a challenge for ABDP under a 2011 U.S. law for automotive sector to move from first-to-invent for patent recognition (i.e. can occur retrospectively) to first-to-file (i.e. whoever files first wins).

However, while patents on actual systems, such as ADAS, are well established (from major manufacturers), there is likely to be less risk to those who supply testing and measurement systems for ADAS. Use of such testing systems also requires know-how, protecting ABDP beyond patent filings alone.

Also, ABDP’s work within ADAS testing relies heavily on its robotic systems for driving vehicles reproducibly in simulated crash environments. These include for path-following and Combined Brake and Accelerator Robot (CBAR).

While application of the robotics to automotive testing is niche and specialist, the underlying robotics are likely well-used in other areas and patents may have limited use or be off-patent. Thus, know-how could be more valuable than just the patents for ABDP.

Reliance on Overseas Sales Representatives, Agents and Distributors

ABDP uses sales agents and distributors in most of its international markets including U.S., Canada, India, Japan, Malaysia, Mexico, Germany, China and Taiwan. These are mostly without formal written terms of engagement.

The risks are that partners could renege on agreed quotas, targets, payments or allocated resources for winning sales. However, generating international sales takes real effort and relies on knowing local business practices, having key relationships and maintaining physical presence.

For a small company such as ABDP operating internationally, there is a trade-off: Do you focus on your core competence? in ADBP’s case, this is developing its proprietary automotive testing systems. Or do you split resource and focus while developing an international sales organization?

Management has chosen the former route and maintained focus on developing proprietary testing systems. While this may compromise control of international sales, it means the company can remain a leader in its testing systems. Many small companies, across sectors, stumble when trying to take on international expansion with in-house sales forces.

Also, risks in using international agents and distributors can be mitigated by partnering with specialists where sales of ABDP’s systems is a material amount of revenue.

Capital Expenditure

The company is at planning stage for a new facility as it expands. This will lead to significant increase in capital expenditure in 2015 and 2016 which will affect cash flow and profits in future years. However, the new facility is to accommodate expansion and the balance sheet is already strong with £7 million cash. It should be manageable without adversely affecting underlying business operations.

Disclosure

I am long ABDP.

This is not a stock recommendation. Any investors reading this agree to do their own research.

Raman Minhas writes about investing using Growth At Reasonable Price to find interesting and profitable opportunities. If you enjoyed this article, join his free GARP newsletter.

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